The resilience of the U.S. economy since the onset of the COVID-19 pandemic has defied expectationsDespite grappling with high inflation and rapidly increasing interest rates, the nominal growth rate has remained robustThis resilience, however, exists alongside significant fluctuations in the financial markets, which have muddied the waters between economic expectations and realityAs we look towards 2025, inflation stands out as a primary source of uncertainty for the U.S. economy, with the advent of a rate-cutting cycle hinting at a complex economic landscape ahead.

Reflecting on the performance of the U.S. economy since the pandemic, it’s clear that inflation is poised to become the biggest unknown in the near futureThe concept of "re-inflation" is now one of the key risks for investors, influenced by new government policies pushing for economic recoverySince 2024, the anticipated rate-cutting cycle may prove tumultuous, suggesting a complicated market outlook moving forward.

A closer examination of U.S. inflation trends reveals a persistent upward pressure, indicating that mid-to-long-term inflation levels may indeed riseThe high inflation cycle that began in 2020 was fueled by pandemic-related impacts and expansive monetary and fiscal policies, with commodity supply shocks acting as the final catalystThe “de-inflation” process initiated in 2024 has been uneven, with core Consumer Price Index (CPI) growth stagnating around 3.3% year-on-yearHousing services remain a significant contributor to ongoing inflation, raising questions about the sustainability of these trends.

The underlying factors driving inflation reflect both endogenous and exogenous events and can generally be classified into four categories: demand shocks, supply shocks, inflation inertia, and monetary policyDemand shocks relate to discrepancies between total societal demand and potential output, while supply-side shocks lead to rising prices of core commodities

Advertisements

Mid-term factors, including labor market dynamics and global economic trends, also contribute significantly to inflationary pressuresWhat’s critical to comprehend is that adaptive expectations create an inflation inertia, where rising inflation expectations can lead to a self-fulfilling cycle of increased current expenditures and wage pressures—this is a phenomenon that can be referred to as the “wage-inflation spiral.” Historical evidence demonstrates that expectations have a strong impact on CPI, adding to the complexity of forecasting future inflation.

Looking ahead, we can anticipate a noticeable elevation in medium- to long-term inflation expectationsThe University of Michigan’s five-year inflation expectations have stabilized around 3%, indicating persistent inflation inertiaStructural Vector Autoregression (SVAR) models suggest that while short-term core inflation may remain manageable in late 2024, long-term core inflation is likely to remain sticky, increasing the pressure for potential re-inflation.

The Federal Reserve’s forthcoming rate-cutting cycle can best be described as “fragmented.” This stems largely from the challenge of swiftly achieving a 2% inflation control targetAs a result, the broader monetary policy is likely to remain watchful and reactivePredictions indicate that the upcoming rate-cutting cycle might extend into late 2025, with anticipated cuts totaling 100 basis points, bringing the terminal rate down to approximately 3.5%. The journey into 2024 suggests a gradual shift, with projected cuts of 25 basis points in December, and additional modest cuts expected in the first half of 2025.

Given the expectation that inflation will maintain around 3%, a terminal rate of 3.5% is still considered restrictiveHowever, the unique challenge presented by sticky inflation underpins the characteristics of this rate-cutting cycleUnlike prior cycles, it is unlikely that a few significant cuts will delineate the entire duration of this period

Advertisements

Each decision made by the Federal Reserve will be contingent on real-time economic data and financial conditions, introducing a level of uncertainty that will likely permeate asset pricing.

The implications of a “rough” rate-cutting cycle for asset prices cannot be understatedVarious asset classes will react differently during this phaseHistorically, a decline in rates is often correlated with a weaker dollar; however, due to the anticipated “rough” nature of this cycle, the prospect of a unidirectional weakening of the dollar seems less likelyIf inflation exceeds expectations, it could shift market sentiment towards a stronger dollar, thus adding a layer of complexity to asset price movements.

As the rate-cutting cycle progresses, the strength of the dollar could increase, particularly as market participants approach the tail end of anticipated cutsIn the face of inconsistent downward pressure on rates, a stronger dollar could emerge as a significant market theme by 2025. For emerging market currencies, a strong dollar introduces substantial devaluation pressure, particularly under the weight of potential trade tariffs and weak export performance.

The performance of U.S. government bonds (Treasuries) warrants close observation throughout the rate-cutting cycleConceptually, rate cuts should lead to lower yields; however, improving mid-term economic outlooks may provoke rising long-term yieldsSuch a scenario might steepen the yield curve as investors grapple with the evolving state of economic stabilityWhile short-term rates will likely adjust closely to Fed decisions, long-term yields are more closely tied to economic fundamentals and inflation trends.

For equities, stable growth in the U.S. economy represents a positive outlookAmong major influences, the technological landscape, particularly as exemplified by firms like NVIDIA, plays a crucial role in shaping stock market trajectoriesStocks heavily invested in AI and technological advancement will particularly influence overall stock performance as economic conditions evolve in response to monetary policy changes.

In summary, as the expectations surrounding “re-inflation” take hold, the divergent performances of the dollar, equity markets, and Treasuries underscore a complex financial environment

Advertisements

Advertisements

Advertisements