Published March 7, 2025
For much of the past four years investors have focused on inflation and the Federal Reserve’s fight against it. While the Fed only controls the very short-term interest rate, their words about potential future Fed moves affect interest rates much further out in time.
In December, the Fed surprised investors by pulling back on expectations for coming interest rate cuts. Inflation has stabilized albeit at levels that might be higher than the Fed would like. But over the past two weeks, interest rates have suddenly fallen sharply, appearing to diverge from the Fed-driven path.
What’s going on? Below, Schwab’s Kathy Jones seeks to answer that question.
“Treasury yields have been falling for six consecutive weeks, with 10-year yields hitting the lowest level since December. Yet consumer surveys still indicate that inflation expectations are high and the Federal Reserve has indicated it is keeping its policy on hold indefinitely. That isn’t the typical backdrop for declining bond yields.
10-year Treasury yields have fallen to lowest level since December
Source: Bloomberg.
U.S. Generic 10-year Treasury Yield (USGG10YR INDEX). Daily data from 3/4/2024 to 3/4/2025. Past performance is no guarantee of future results.
What’s happening? To reconcile the market move with the data, we look to expectations. As we’ve pointed out several times, in general, government policies that impose trade barriers and limit immigration have the potential to raise inflation in the short run and slow growth in the long run. It looks like the bond market has decided to bypass short-term inflation concerns and focus on the long-term prospects. As a result, the yield curve has inverted again with the fed funds rate higher than yields for all maturities.
Treasury yields are below the upper bound of the federal funds rate
Source: Bloomberg.
U.S. Treasury Actives Curve (GC C15) and Federal Funds Rate – upper bound (FDTR Index). Data as of 3/4/2025.
So far, the economic data aren’t pointing to recession, but there are warning signs of a growth slowdown. Fourth-quarter gross domestic (GDP) growth came in at a healthy 2.3% pace, driven primarily by consumer spending. However, the early data for this year suggest a slowdown is in the making.
The various Federal Reserve Bank surveys have shown more caution among businesses. The Philadelphia Federal Reserve’s Manufacturing Business Outlook Survey results, shown in the chart below, are consistent with other reserve bank findings: New orders and hiring are down while prices are up. Comments from businesses across the country focus on the uncertainty surrounding tariffs and the potential negative impact on orders.
The Philly Fed survey reflects a recent downturn in activity
Source: Philadelphia Federal Reserve.
Business Outlook Survey Diffusion Index (SA, % of Balance/Diffusion Index). Components include Prices Paid (OUTFPPF Index), Number of Employees (OUTNEF Index), New Orders (OUTNOF Index), Prices Received (OUTPRF Index). Monthly data from 9/20/2018 to 2/20/2025.
The Manufacturing Business Outlook Survey is a monthly survey of manufacturers in the Third Federal Reserve District. Participants indicate the direction of change in overall business activity and in the various measures of activity at their plants: employment, working hours, new and unfilled orders, shipments, inventories, delivery times, prices paid, and prices received. The diffusion index is computed as the percentage of respondents indicating an increase minus the percentage indicating a decrease. The data are seasonally adjusted.
In addition, real personal spending showed a steep drop in January after a year of monthly gains. Lousy weather in much of the country may have contributed to the decline, but it was much weaker than expected and is an indicator that bears watching.
Real personal spending declined in January
Source: US Personal Consumption Expenditures Chained Dollars (PCE CHNC Index). Monthly data from 2/28/2021 to 2/28/2025.
Data is from the monthly Personal Income and Outlays report published by the Bureau of Economic Analysis, which reflects consumer earning, spending and saving.
Perhaps all of the news about mass layoffs in the federal government and cutbacks in services combined with the prospects of a trade war have soured the outlook for consumers. We always go by the mantra that you should watch what consumers do and not what they say. Consequently, it will take more evidence of a shift in consumer behavior to know whether the drop in sentiment is translating into a sustained drop in spending.
The January unemployment report should provide some insight. To date, the job market has remained healthy, with the unemployment rate remaining low near 4% and job growth surprising on the upside. Under the surface, however, job openings and the pace of hiring have slowed. Those trends have been offset by a relatively sluggish pace of layoffs. The federal government layoffs won’t likely show up in the data right away, but it may be hanging over the market and consumer sentiment. It’s worth noting that for every federal government worker, there are an estimated two contractors in the labor market. Contractors often are the first to be laid off. An uptick in weekly initial jobless claims during the week ending February 22nd may just be a fluke but if the trend continues, it would be a signal of a slowdown.
Jobless claims jumped recently
Source: Bloomberg.
US Initial Jobless Claims SA (INJCJC Index) and US Continuing Jobless Claims (INJCSP Index) Weekly data from 11/4/2021 to 3/4/2025.
The weekly jobless claims report tracks the number of unemployment insurance claims reported by each state’s unemployment insurance program offices. It is considered a leading indicator of the monthly U.S. employment report.
Inflation is still too high for the Fed
While the drop in yields points to the market’s focus on waning growth prospects, it is worth noting that inflation is still above the Fed’s 2% target. The recent Personal Consumption Expenditures (PCE) price index report for January indicated some easing in pressures, but at 2.5% for overall PCE and 2.6% for core PCE (excluding volatile food and energy prices), inflation is still too high for the Fed to consider another rate cut.
Moreover, with the tariffs on goods from Mexico, China, and Canada, inflation risk is likely to revive. These countries are major U.S. trading partners. Consequently, there is a lot at stake for the economy.
There is a lot at stake for the Federal Reserve, as well. Inflation is too high and the outlook too uncertain for easing policy, but slower growth longer term could warrant it. No one at the Fed is arguing for it to abandon the 2% inflation target. It has been in place since the 1990s and is the standard for most major developed market central banks. With so many factors at odds, all the Fed can do is wait to see what happens next.
Inflation eased in January, but remains above the Fed’s 2% target
Source: Bloomberg.
PCE: Personal Consumption Expenditures Price Index (PCE DEFY Index), Core PCE: Personal Consumption Expenditures: All Items Less Food & Energy (PCE CYOY Index), percent change, year over year. Monthly data as of 1/31/2025.
Meanwhile, at least half of all consumers are worried about rising prices (expectations tend to diverge along political party lines). Egg prices, which have been a major reason behind consumer inflation concerns, have yet to fall (the average price for a dozen Grade A large eggs was $4.95 in January, compared with $2.04 in August 2023, according to the Bureau of Labor Statistics). With the agencies reporting on bird flu now limited in their ability to report due to federal job cuts, we don’t know what to expect—yet another source of uncertainty for consumers.”
Market Update
Stocks kicked off the first trading day of March with a -1.8% drop. President Trump announced 25% tariffs on goods coming from Mexico and Canada, seeming to catch traders off-guard. Meanwhile, European defense stocks soared as the European countries pushed for higher defense spending in the wake of Trump’s backing away from support of Ukraine (and by extension, NATO). Another -1.2% fall Tuesday as financial stocks suffered a -3.5% rout. The group had been the only cyclical sector holding up amid the recent market selloff. But a sharp downward revision to the Atlanta Fed’s widely-watched GDPNow model amped up talk of a coming recession. (The GDPNow model shifted dramatically to a -2.5% economic contraction for the first quarter down from a +2.5% GDP gain projection held in February.) Wednesday morning continued the downdraft before buyers swooped in to reverse indexes upward. A one-month pause in the Canada/Mexico tariffs on autos helped as did a second day of rising interest rates. Stocks rebounded by +1.1%. But it was a very brief reprieve as indexes suffered their worst day in months Thursday. The Nasdaq fell -2.6% to reach a -10% decline from the December peak. Semiconductor and other tech leaders were slammed with AI chipmaker Marvell’s earnings underwhelming investors leaving the stock off -20% in Thursday’s trade. Friday brought a monthly jobs report that met expectations. Traders largely looked past the data instead awaiting the next monthly report that will begin showing the effects of widespread Federal Government labor cuts. A morning pullback found buyers though as stock indexes recovered to post a +0.6% gain.
The worst week in many months for the stock market this week found the S&P 500 (SPY) down -3.07% but sitting on its long-term moving average – which has held as support for over two years. The Nasdaq 100 (QQQ) fell -3.22%, also recovering Friday afternoon to very near it’s long-term average line. Small-cap stock (IWM) plunged -4.05% for the week. The index has now given up the prior eight months worth of gains.
Warm wishes and until next week.