In recent weeks, financial markets have been responding dynamically to new realities shaping the global economy. Shifts in asset prices, evolving inflation expectations, and diverging economic trends are creating a complex landscape for investors. Let’s break down the key developments and their implications.

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Asset Prices React to Economic Realities

Investors have been absorbing significant shifts in economic conditions, including:

• A stronger-than-expected U.S. economy.
• Persistent inflation in both the U.S. and Europe.
• The growing likelihood of U.S. trade restrictions.
• Adjusted expectations for U.S. Federal Reserve policy.

One immediate effect of these developments has been a rise in inflation expectations. The 10-year breakeven inflation rate—a measure of expected average inflation over the next decade—climbed from 2% in early September 2024 to 2.4%. This shift was influenced by robust U.S. employment data and concerns over potential changes in trade policy.

These inflation expectations have, in turn, reshaped views on Federal Reserve policy. Futures markets now suggest only a 17% probability of rate cuts by the end of 2025, up from 9% just a week earlier. Consequently, yields on U.S. government bonds have surged, with the 10-year Treasury yield nearing 4.8%, its highest level since October 2024.

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Currency and Commodity Movements

The rise in bond yields and potential U.S. tariffs have propelled the U.S. dollar to new heights. The euro approached $1.02—its lowest since 2022—while the British pound dropped to $1.215, its lowest since 2023. A stronger dollar can temper U.S. inflation but poses inflationary risks for other countries, even as it boosts their export competitiveness.

In the commodities market, crude oil prices have climbed despite the dollar’s strength. West Texas Intermediate (WTI) and Brent crude prices have risen approximately 10% since the start of the year, driven by sanctions on Russia’s oil sector. These sanctions have disrupted global oil supply chains, particularly affecting Indian and Chinese refiners, who are now seeking alternative sources of crude.

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Diverging Borrowing Costs in the U.S.

An unusual divergence has emerged in the U.S. between short- and long-term borrowing costs. Despite the Federal Reserve cutting its benchmark interest rate by 100 basis points since September, the yield on the 10-year Treasury bond has risen by the same amount. This counterintuitive trend can be attributed to:

1. Rising inflation expectations: Investors anticipate higher future short-term rates due to proposed fiscal policies, including tax cuts and tariffs.
2. Concerns over the U.S. budget deficit: With the deficit exceeding 6% of GDP, fears of increased government borrowing are mounting.
3. Robust economic growth: Faster-than-expected growth is driving demand for credit.
4. Foreign diversification: Central banks may reduce U.S. debt holdings to support their currencies against a strong dollar.

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Positive Inflation Surprises in the U.S.

Investors recently welcomed favorable inflation data for December, despite a rise in headline inflation to 2.9% year-over-year. Core inflation, which excludes volatile food and energy prices, decelerated to 3.2%—its lowest rate since August 2024. The primary driver of higher headline inflation was energy prices, but several factors, including increased U.S. production and China’s transition to electric vehicles, are expected to limit future energy inflation.

The slowdown in core inflation, particularly in the services sector, further buoyed investor sentiment. For instance, service inflation, excluding shelter costs, reached its lowest level since early 2024. This trend led to lower bond yields, a weaker dollar, and a near 2% rally in U.S. equity markets.

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China’s Economic Landscape: Mixed Signals

China achieved its 2024 GDP growth target of 5%, driven by strong export performance and industrial production. However, domestic demand remained subdued, with slow growth in retail sales and fixed asset investment. Key highlights include:

• Exports: Up 10.7% year-over-year in December, driven by strong sales of electric vehicles and solar panels. However, frontloading due to anticipated U.S. tariffs may dampen future export growth.
• Domestic demand: Retail sales rose modestly, but government stimulus appears to be shifting rather than expanding demand.
• Property sector: A significant drag on growth, with declining property investment and falling residential property prices.

China’s record trade surplus of over $1 trillion in 2024 underscores its reliance on external demand. While some view surpluses as a sign of strength, they often reflect weak domestic demand or limited investment opportunities. The government’s ongoing efforts to stimulate consumption and investment aim to address these imbalances.

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The interplay between inflation expectations, Federal Reserve policy, and global trade dynamics will continue to shape financial markets. Meanwhile, China’s balancing act between domestic and external growth drivers remains critical. Investors should stay vigilant, as the economic and policy landscape evolves, presenting both risks and opportunities.