2025 already has provided quite a bit of excitement if you’ve been keeping your ear to the ground, listening to the goings on across the world.
We’ve had, at last count, no less than three governments within developed countries fail within the last few months. France, Germany, and South Korea have all had large political disruptions causing coalitions to break apart and leaders to relinquish their top posts.
Canada and the United Kingdom appear to be right behind them in terms of political volatility. In the UK, they’ve had five Prime Ministers (famously, Liz Truss was in office for only 49 days) since 2019, and they may be onto their sixth in short order! Meanwhile, here in the United States, we’re getting ready to usher in a new political regime where change is undoubtedly expected.
I bring all this up not to cause concern, but instead to point out that even when large disruptions occur in the political world, this often doesn’t materialize in the economic world. At least not to the extent the media coverage these events warrant would suggest.
The S&P 500 notched 56 new all-time highs throughout 2024, the fifth most in any given year since the 1950s. The U.S. GDP, a common measure of economic output, is expected to have grown 2.7% in 2024. Bond returns held relatively steady throughout the year as well.
Given how much has changed politically in the recent past, it would stand to reason there could be impacts as a result of these changes in the future. As we just detailed, these changes often don’t occur all at once. However, there are ways to “read the tea leaves” and come to a few conclusions of our own.
One of the most common ways to observe how the market is anticipating future changes is to look at U.S. Treasury bond interest rates, specifically the interest rate on the 10-year bond. Through this lens, these are the three things we’ll be keeping an eye on in 2025 as told by recent moves in the 10-year Treasury Bond.
Inflation
We’ve seen an incredible shift in inflation rates over the past few years. Peaking at 9.06% and falling to its current rate of 2.75%, the roller coaster ride of inflation has been a volatile one. Unfortunately, even though we’ve seen inflation fall back closer to the Fed’s 2% target, we believe this could be one of the largest risks looming underneath the surface.
Despite the moderation in some of the largest components of inflation, we still see risks to the upside in prices as the federal government seeks to extend tax cuts without commensurate federal spending cuts. As the Federal Reserve cuts rates, this has a stimulative effect on the economy, which tends to drive greater demand for employees and places upward pressure on wages. If taxes remain low and wages increase, this can place upward pressure on the price of goods and services. The recent increase in government bond yields suggests the market may be anticipating this risk as well.
Government Spending
On the topic of tax cuts, Washington appears to remain unconcerned about the impact of continued fiscal stimulus through future spending promises. The newly created Department of Government Efficiency is targeting a $2 trillion cut from the budget. Though, even Elon Musk believes this is a “best case” scenario and thinks the number might be closer to $1 trillion. Whatever the number ends up being, the proposed cuts at $2 trillion, or less, are not enough to offset the federal deficit under the proposed legislation by the incoming administration.
The reason fiscal deficits may matter more in the future than they have in the past is because it’s going to cost our government more to run these deficits as a result of higher borrowing costs. As the yield demanded for government bonds increases due to the perceived risk of higher spending, it will cost the U.S. more to issue debt to pay for that spending.
For example, in 2015, if the government wanted to issue new 10-year Treasury Bonds to fund their spending, it would cost them 2% per year to pay interest to the buyers of that debt. Today, it costs over double that amount at 4.7% to issue 10-year bonds. To put this into perspective, it cost the U.S. $169 billion in 2024 to pay the interest on our outstanding bonds. That represents 13% of our total expected spending for 2025. That’s the fifth largest source of spending behind the Department of Health and Human Services ($452B), the Social Security Administration ($395B), the Department of the Treasury ($355B), and the Department of Defense-Military Programs ($250B).
Economic Growth
One of the ways to help offset government spending is to have an economy that’s stable and growing. If your economy is growing, investors generally want to experience that growth in their investments. The best way to do this is to own stocks. Because most investors are fully invested between stocks and bonds, in order to invest more into stocks, they’ll need to sell bonds to fund their purchase. The sale of these bonds causes the yields to rise due to the increased supply of bonds being sold from investor’s portfolios.
We can see how these factors – inflation expectations, unchecked government spending, and economic growth – can potentially be a volatile cocktail for higher yields. Within limits, these are all tolerable phenomena. We generally want some inflation, some government spending, and stable economic growth. However, if any one of these factors gets ahead of itself, especially with interest rates already at elevated levels, it could stifle the government’s ability to spend or the economy’s ability to grow. To be clear, this isn’t just an issue for the U.S. Many other developed nations are struggling with the same problems.
Every year is a new year, and there’s no telling how it will all shake out until we’re looking back on 2025 from our chairs in January 2026. We believe these will be the three most followed storylines throughout the year, and therefore the most likely to disrupt the markets.
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The opinions voiced in this material are for general information only and are not intended to provide specific investment or tax advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
