Word of the Year? Caution…

In the September edition of this newsletter, “Soft landing?” I explained the basis of the Fed’s highly anticipated rate cuts and presented several market indicators, such as the un-inversion of the yield curve. These indicators implied a future recession expectation by the markets and hinted at potential market volatility, creating opportunities for asset allocation adjustments.

Indeed, the September Fed fund rate cut of 50 basis points spurred immediate gains. However, uncertainty surrounding the economy, coupled with bleak economic data from China, tempered long-term market optimism. With the conclusion of the U.S. elections in November, the Fed's decision to implement another rate cut of 25 basis points—and signals of fewer rate cuts in 2025—we seem to be entering 2025 with mixed feelings.

On one hand, the U.S. economy continues to demonstrate resilience. Healthy payroll data and solid consumption spending, alongside a continuing disinflation trend, are positive signs. However, there are emerging signs of weakness, particularly in U.S. households, as credit card delinquency rates increase. Furthermore, the Fed’s recent projection indicates heightened inflation risks due to expected policy changes in U.S. tariffs and immigration.

While delinquency levels are not comparable to those during previous recession periods, household affordability remains a concern. A future inflationary era, potentially fueled by U.S. policies, could further strain household finances. Historical recession data on delinquency levels suggest potential loss rates that might escalate under these conditions.

How Are Markets Reacting?

Let’s revisit a key indicator discussed earlier: the Treasury market’s yield curve. In September 2024, the 10-year benchmark rate finished above its shorter counterpart for the first time since 2022. This un-inverted yield curve phenomenon traditionally signals the final phase before a recession.

Since September 2024, the term premium lingered around zero. However, in the last week of 2024 and the first week of 2025, the spread between the 10-year and 2-year Treasury yields began to increase. This indicates market expectations of rising inflation and skepticism about reduced rates in the near future.

While these indicators do not necessarily predict future events, they provide insights into market sentiment. Despite positive news about the U.S. economy, markets seem more focused on risks. For instance, the anticipated year-end “Santa rally” failed to materialize in U.S. stock markets. The S&P 500 declined by 2.5% in December, despite soaring 23% over the course of 2024.

Given that mortgage rates are influenced by long-term U.S. Treasury yields rather than the Fed’s fund rate, the 30-year Treasury yield reaching 5% has pushed Freddie Mac’s national average for 30-year fixed-rate mortgages near 7%. This is a significant jump from levels nearing 6% during the Fed’s cutting cycle in early fall 2024. The persistence of high mortgage rates and declining affordability poses concerns for the U.S. housing market and could have broader economic implications, particularly in the second half of 2025.

Global Perspectives

Globally, a significant portion of developed economies, as defined by the IMF, are employing monetary easing measures but are closely watching the Fed’s actions.

In Türkiye, the monetary policy rate was reduced from 50% to 47.5% during the last MPC meeting and is expected to gradually decline to 40% in 2025. The Turkish lira appears stable against hard currencies due to the substantial interest rate gap supporting carry trades. However, this stability remains vulnerable to shifts in global sentiment, particularly if idiosyncratic events trigger a flight to safe assets. For Turkish households, ongoing inflation continues to erode affordability and strain finances.

A Call for Caution in 2025

For financial institutions, corporates, and individual investors, the word of 2025 should indeed be “Caution.” If you are a Board member or Chief Executive Officer, strengthening the risk culture of your organization would be a prudent investment in the coming year. For individual investors, reflecting on risk-adjusted returns and reassessing portfolio allocations, especially considering market dynamics of an upcoming Trump era for US policies, would be wise.

?Wishing you all a healthy and prosperous 2025! Stay safe and strong as we navigate 2025 together.

If you have any questions, please contact Alper Eker

[email protected]