The Risks the US Economy Is Facing in 2025

Last week turned out to be a wild one in the markets.  As expected, the Fed continued to lower rates, dropping the Fed funds rate by twenty-five basis points, but the market reacted horribly to the rate cut.   Stocks sold off sharply and left many investors stranded with fresh long positions at all-time high prices. More specifically, the market reacted horribly to Powell’s comments after the rate move as he noted that the Fed will have to slow down the pace of future rate cuts and maintain a more restrictive interest policy due to the persistence of inflation in the economy.  He noted that the employment market remains solid, so he finally recognized that the Fed needs to focus on addressing the very real problem of inflation rather than the fear of potential weakness in the employment sector.  I will address this shortly, but first I want to focus on Powell’s insistence that the current level of interest rates in the US is restrictive. 

According to the Fed’s own financial conditions index, financial conditions are now at their loosest levels since 2021 – long before the Fed started hiking rates in response to the dangerously high inflationary pressures that the Fed created when they simply pumped way too much money into the system in response to the covid-induced recession.

Ever since Alan Greenspan served as the Chairman of the Fed from 1987 until 2006, the Federal Reserve Bank has erred on the side of keeping economic policy extra loose, lowering rates and pumping money into the economy at every sign of economic weakness.  This strategy works fine during a macro disinflationary cycle, but it is a remarkably dangerous policy to follow during inflationary cycles.  Still, it is a policy that Powell seems intent on following to the bitter end.

The globalization process that dominated Greenspan’s era as Fed chairman was marked by a steady supply of inexpensive imports from low-cost producers such as China, and these cheap imports helped reinforce the disinflationary cycle in the global markets that essentially made Greenspan, and his successors often look like economic wizards.  The economy kept chugging along despite periodic bumps due to intense, but short-lived recessions.  The Fed’s policy of pumping money into the system to address any economic weakness continued to work, and the equity markets thrived overall despite several vicious, market meltdowns.  Inflation remained quite tame during this entire period despite extremely loose economic conditions as the cycle of disinflationary pressures kept a serious lid on general price rises in the economy.

That cycle ended in 2020, and suddenly the Fed chairman, Jerome Powell, did not look so prescient.  His low point as chairman was probably marked by his famous forecast that inflation was transitory, as this forecast proved to be dramatically wrong.  In fact, it was among the worst economic forecasts on record of any Fed chairman, although I think that the title of the worst economic forecast by a Fed chairman (or leading economist) could be hotly debated. In my opinion, Ben Bernanke might actually hold this honor.  In 2007, then-Fed Chairman Ben Bernanke downplayed the potential impact of the subprime mortgage crisis, stating that it was "contained" and unlikely to cause significant economic damage. This forecast was proven disastrously wrong as the crisis escalated into a global financial meltdown shortly after his ill-timed comments. There have been many other terrible forecasts by top economists, so Powell shouldn’t feel too special.   

Just for amusement purposes I will share several others.  In September 2007, after his tenure as Fed chairman had ended, Alan Greenspan published a memoir called The Age of Turbulence: Adventures in a New World.  In the book, Greenspan maintained that the economy was hurtling towards double-digit interest rates due to his expectation of rising inflationary pressures.  According to Greenspan, the Fed would be compelled to drastically raise its target interest rate to fulfill its two percent inflation mandate. One year later, the Fed Funds rate was at historical lows, reaching zero shortly after.

Greenspan’s timing couldn’t have been much worse.  One more candidate worth considering for the all-time winner of the worst forecast ever might be held by Irving Fisher.  Fisher was one of the great economists of the first half of the 20^th century, but he unfortunately went on record forecasting a stock market boom right before the market crashed in 1929.  Therefore, in light of Bernanke’s bungled forecast, along with the awful forecasts of Greenspan and Irving Fisher, I am afraid that Powell’s “transitory” forecast, although remarkably wrong, doesn’t earn the highest honors among lousy forecasts.

I used to maintain a mythical “Wall of Shame” in my trading room as a way to tease my traders when they made particularly bad trades or bad market forecasts.  I would tell them that their trade was so bad that it earned the distinction of being commemorated with a plaque on a Wall of Shame in the trading room. In fact, there were no such plaques, and the idea that a terrible trading idea earned a Wall of Shame distinction was simply my way of teasing one of my traders for a particularly lousy trade idea.  I always found that being able to laugh at our terrible ideas was a healthy way to keep a proper balance with our trading.  Even the best traders get many trades wrong.  In fact, if a trader can be right on just 40% of his trade ideas, he can still make a lot of money as long as his risk management is good.  Of course, many of my own trades earned such a distinction.  In fact, we did keep a journal of these terrible trades, but we never made the plaques.  

The funny thing is that I once told a friend of mine, the Chief Dealer at BNP Paribas, about our Wall of Shame, and he thought there really was such a wall.  As luck would have it, shortly after I told him about our Wall of Shame, he put on a particularly large position at precisely the wrong time, buying a couple of hundred million dollars against the yen moments before dollar yen started crashing lower.  I told him that we had already ordered a plaque commemorating his awful trade, and that from that day on, our guests would be able to laugh at his terrible purchase of dollars at the top of the market.  The poor guy was more upset about being put on the Wall of Shame than the fact that he lost a few million dollars for his bank in minutes.  He started calling me constantly, begging me to remove his plaque from the wall.  I finally admitted that there really wasn’t such a wall, but he didn’t believe me.  I invited him to the office for lunch to see for himself that his terrible trade was not going to be recorded in infamy, so he finally relaxed.  We became good friends and I ended up hiring him, so if he is reading this, I am sure he will certainly remember the story.

In any event, Powell’s forecast about the transitory nature of our inflation was remarkably incorrect.  Inflation has proved to be anything but transitory.  Years later, price pressures remain high, and the cumulative price rises played a key role in the election of Donald Trump as our next President. Tens of millions of Americans are struggling economically with the high costs of housing, goods, and services.  While the pace of price rises has slowed, the current price levels reflect all of the prior price hikes.   

Although I have complained about some of Powell’s policies for many years, I have to confess that I have a new-found respect for him.  It turns out that he can speak backwards.  I saw him in an interview, and he demonstrated this bizarre skill. He can visualize a sentence and then “read” each word backwards, out loud.  That is not an easy feat, so despite my complaints about some of his questionable policy moves, I do have a serious level of respect for his ability to do something that almost no one else can do.  (You might want to spend a couple of minutes trying this.  It is seriously difficult.)

In terms of the markets, Powell’s comments (spoken in normal English after the Fed’s rate cut rather than backwards) certainly put the kibosh on the market’s seemingly inexorable climb to fresh all-time highs every day.  Powell pointed out the obvious, i.e. that the economy was still on solid footing, that the job market was holding together just fine, and that there was limited scope for further rate cuts in 2025 due to the persistence of stubborn inflationary pressures.  The market really didn’t like what it was hearing, as the speculators prefer the idea that the Fed will keep cutting rates indefinitely.  A market rout ensued.  I think the following chart pretty well sums up how ugly things got after the rate cut.  

At the same time the yield on 10-year and 30-year treasuries seemed generally unaffected by the rate move as interest rates simply continued their climb higher. Ever since the Fed’s rate cut in September, rates have been rising sharply.  Clearly, the market strongly disagrees with Powell’s continued assertion that rates in the US were restrictive. In fact, a continued rise in bond yields might prove to be the proverbial straw that finally breaks the back of the stock market’s amazing rise. 

Inflationary pressures in the US are still quite strong, and the Fed’s comments about monetary policy being restrictive are no longer accepted as being serious.  Sure, the Fed wants the economy to keep chugging along, and they want inflation to finally head down towards their mythical 2% inflation target, but their claim that interest rates are restrictive is just ridiculous.  Yes, the nominal level of interest rates is a lot higher than it was for many years, but it is hardly restrictive by historical terms.  This chart clearly demonstrates that the market is expecting treasury yields to rise, not fall, and that Powell’s interest rate cuts are hardly predictive of future market behavior.

As a point of interest, you will see in the following chart that the current 10-year bond yield is not very restrictive by historical standards.  It might seem high relative to the more recent period since the Great Recession when the Fed went wild with monetary easing, but in the big picture, this has been an anomalous period.

I have highlighted the general decline in yields during the disinflationary cycle, although it should be quite clear that the long-term downtrend in rates is broken, at least for a while. Going forward, I believe that the US equity market will be marked by increasingly violent price action.  There have been many seemingly contradictory developments that will likely lead to wild market gyrations.  I am going to address some of them below, but we should not underestimate the potentially explosive combination of recent record investor inflows into the stock market coupled with Trump’s new economic policies.  Historically, record inflows of investor capital into stocks has almost never been a good sign.  We should generally be looking to buy when other people are selling in a panic, not when they are going all in. Yes, in a bubble, there can be a short-lived parabolic rise when people go all in, but parabolic rises usually result in parabolic declines afterwards.

The U.S. economy is currently facing multiple key risks:

1. Inflation: While inflation has been moderating, it remains a concern. Recent price increases have been stickier than expected, and one-off shocks, such as bird flu affecting egg prices, continue to pose challenges.  The impact of Trump’s tariffs remains to be seen, but they could prove to be quite inflationary.  In fact, we could easily face an ugly scenario of rising inflation, declining earnings, heightened geopolitical risks, softer corporate earnings, and rising bond yields.
2. Federal Reserve Policy: The Federal Reserve's decisions on interest rates are a significant wild card. Higher interest rates can help control inflation but also increase borrowing costs for consumers and businesses.  Clearly, the Fed will want to protect the stock market and risk higher inflation, but even the Fed will have limits to how far astray they can go with their policies. 
3. Trade Policies: Proposed tariffs and trade policies, especially with major trading partners like China, could significantly impact consumer prices and economic stability.  There will also be tangential impacts on Australia, New Zealand, Mexico, Canada, Japan, and Europe.  In other words, the impact will be global.
4. Labor Market Conditions: The labor market is expected to soften, with the unemployment rate projected to rise slightly. This could lead to reduced consumer spending and economic growth.  This could also occur at precisely the worst time, since rising price pressures could put the Fed in a terrible double-bind – hike rates to lower inflation or lower rates to support a softer jobs market, further reinforcing the inflationary tendencies.
5. Global Economic Conditions: Economic slowdowns in other countries, particularly China, can affect U.S. exports and overall economic performance.  This will also affect Japan and the rest of Asia – potentially, quite dramatically.
6. Geopolitical Tensions: Ongoing geopolitical tensions, such as the conflict in Ukraine, can create economic uncertainty and disrupt global supply chains.
7. Rising Bond Yields:  The fiscal time bomb in the US is ticking, and we could easily see 6% yields in 10-year treasuries.  That could lead to a rout in equities of at least 10%, maybe much more over time.
8. Weakening Consumer Confidence: If consumers start to cut back on spending due to economic uncertainty, rising costs, or rising bond yields, then corporate earnings could be heavily impacted.
9. Corporate Earnings: If companies report weaker-than-expected earnings, it can lead to a decline in stock prices as investors reassess the value of those companies.

The bottom line is that US equities are largely priced to perfection.  The current P/E ratio for the S&P 500 is around 28.92, which is significantly higher than the historical average of around 20. This elevated P/E ratio suggests that stocks are relatively expensive compared to their earnings.  To put it into perspective, the current P/E ratio is about 79.2% above the modern-era market average of 20.4, making it 2.0 standard deviations above the modern-era average. In fact, the market is strongly overvalued and vulnerable to a potentially violent downside risk.  

Do I expect this to happen immediately?  No.  Am I happy to start building some positions that will capitalize on possible turmoil in equities over the coming year?  Absolutely.  I was going to write about some individual stocks for this write-up, but I felt that addressing some of the macro issues first was more important.  I will be sending out a second letter in a few days, and I will provide more specific actionable ideas on the market in that letter. 

I will also address gold, the currencies, and a couple of other ideas for the new year.  In the meantime, I wish you all the best of luck with your trading.