Key Takeaways on Inflation and the US Stock Market
• A series of strong economic reports on inflation and jobs have investors more concerned about inflation in 2025 than they were just a few months ago.
• Sticky inflation and a strong economy are reshaping the Federal Reserve’s outlook for rate cuts. Investors now see the Fed holding rates at a higher level for longer.
• Both stocks and bonds have struggled to adjust to the new outlook, with inflation-sensitive stock sectors underperforming and bond yields climbing.
• Investors expect strong economic growth to accompany stubborn inflation in the months ahead—a silver lining for markets over the long term.
The specter of inflation is again looming over the markets. Bond yields have surged, and stocks have been stuck in the doldrums over that same period, unable to break out of a holding pattern. Market watchers have pointed to a slew of reasons for the malaise, from concerns about a growing federal deficit to regular end-of-year portfolio reallocation to anxiety surrounding a much-reduced outlook for interest rate cuts from the Federal Reserve in 2025.
Inflation underpins many of these explanations. Problematic price pressures appeared to be vanquished last fall, but it currently looks like they might stick around for at least another year. That has implications for Fed policy, and by extension stocks and bonds.
CPI vs. Core CPI
Bureau of Labor Statistics.
The result is an environment in which “investors seem to be shifting their concerns towards prolonged inflation or even worse, a rebound in inflation,” says Dominic Pappalardo, chief multi-asset strategist for Morningstar Investment Management. He points out that bond yields have risen sharply even though the Fed has cut rates by a full percentage point since September.
Here’s what investors need to know about how inflation worries impact markets.
What’s Changed in the Markets?
Stocks soared in the aftermath of the November election, as markets cheered the prospect of a pro-business administration under President-elect Donald Trump. Bond yields soared too—generally a negative for equities—but stocks hit record after record anyway.
Stocks’ upward momentum abruptly halted in December after the Fed dramatically pared back its forecasts for interest rate cuts in 2025 amid robust economic growth, a handful of sticky inflation prints, and (analysts speculated) uncertainty about the inflationary impact of potential policies from the new administration. Investors now know this uncertainty was a major factor in the central bank’s decision.
“Participants expected that inflation would continue to move toward 2%, although they noted that recent higher-than-expected readings on inflation, and the effects of potential changes in trade and immigration policy, suggested that the process could take longer than previously anticipated,” read the minutes from last month’s Fed meeting.
Bonds sold off along with stocks in the aftermath of that meeting, with losses in the sector deepening last week amid strong economic data. Bond yields (which move in the opposite direction of prices) spiking even after previous rate cuts are a window into investor anxiety. The yield on the 10-year Treasury note flirted with 4.8% on Friday, its highest level since 2023.
The “moves suggest investors at a minimum don’t believe the Fed will be able to continue to reduce rates, as inflation concerns will supersede the desire to stimulate economic activity, or in a worse case, will have to resume the fight against prolonged above target inflation rates,” Pappalardo explains.
Long-Term US Treasury Yields
Source: Federal Reserve Economic Database.
Are Bond Investors Worried About Inflation?
It’s not just yields. Analysts point to a handful of signals from the bond market that suggest inflation is top of mind for investors. Sameer Samana, senior global market strategist at the Wells Fargo Investment Institute, cites three metrics: inflation swaps, the breakeven rate, and the term premium. All are measures of the bond market’s expectations for growth and inflation in the months and years ahead.
Inflation swap trades contain implied inflation expectations. Samana says those traders are looking at inflation of roughly 2.6% a year from now—a full percentage point higher than in late summer. The breakeven rate comes from the difference between inflation-protected bonds and Treasury bonds (which are not inflation-protected). Samana says the difference between the yields on a one-year TIP and a one-year Treasury has risen over the past few months and is now about 2.8%—a good proxy for the market’s best guess for inflation over the next year. Lastly, the term premium has recently turned positive, meaning that investors are demanding more compensation for locking their money up with the government for a longer period.
Based on the movement in those metrics, Samana says, “It’s fair to say that the market is getting more worried about inflation.” At the same time, however, they’re signaling that investors expect more economic growth.
What’s Driving Inflation?
Growth is critical to the inflation story because it helps investors understand why inflationary pressures persist. “Is [inflation] happening because the economy is strong, demand is strong, [and] consumers are still spending?” asks Jason Draho, head of asset allocation Americas, UBS Global Wealth Management. That would be a sign of economic strength. “Or is it happening because of cost pressures in the economy?” These include the supply-side issues that pushed inflation to multi-decade highs after the covid-19 pandemic. “The more [inflation] is a result of good growth, the better,” Draho opines.
He says that’s the message markets are sending. “The interest rate market is basically saying that inflation is kind of sticky, but it’s mostly because growth is holding up far better than expected.” He believes that despite the uncertainty surrounding future Trump administration policies and their potential inflationary impact, rates traders expect them to be good for growth.
How Do Inflation Expectations Impact the Stock Market?
Draho suggests that the market holding relatively steady despite rising yields is a sign that stocks have healthy growth expectations built in. “If you take the overall picture of what the markets are pricing,” he says, it’s that the rise in rates, while not ideal, is driven by strong economic growth.
Jeff Schulze, head of economic and market strategy at ClearBridge Investments, expects today’s higher rates to bite stocks harder than they would have a few years ago, during the early stages of the bull market. “Since we’re a little bit more later cycle and equity markets are more fully valued, you’re feeling that impact much more acutely at this point,” he explains.
Investors are already responding. Lara Castleton, US head of portfolio construction and strategy at Janus Henderson Investors, says she saw more moves into large-cap stocks among the firm’s clients last quarter. Smaller-capitalization stocks, which are more sensitive to higher interest rates and higher inflation, were a less popular trade. “Inflation is starting to become investors’ biggest concern in 2025,” she says.
Rate-Sensitive Stocks Underperform
Under the hood, analysts say the performance of stock sectors can also be a window into how investors think about inflation. Samana points out that the sectors that have recently underperformed the broader market, like consumer defensives, tend to be more sensitive to inflation.
“Rate-sensitive groups have really seen a pronounced deterioration over the last month,” adds Schulze. He points to real estate stocks alongside consumer defensives. He says rates moving higher from today’s levels could be an “impediment for the market.”
On the other hand, sectors that can pass along inflationary costs and benefit from higher growth, like consumer cyclicals, have performed better.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar's editorial policies.
