Think the Stock Market Will Soar Again in 2025? The Bond Market Could Be Signaling Otherwise.

The bulls continue to run rampant on Wall Street. Most analysts believe the S&P 500 (SNPINDEX: ^GSPC) will deliver strong gains again this year, after jumping 23% in 2024. Some point to investment in artificial intelligence (AI) and the potential for corporate tax cuts and deregulation in a second Trump administration as likely tailwinds.

But will the stock market really soar again in 2025? The bond market could be signaling otherwise.

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Image source: Getty Images.

Rising yields despite rate cuts

Ordinarily, there is a direct correlation between interest rates and bond yields, especially the yields of short-term bonds. When rates rise, newly issued bonds typically offer lower coupon rates, reflecting lower borrowing costs. Existing bonds with higher yields become more attractive than newer bonds. This increased demand causes their prices to rise, pushing their yields down, since the yield is the bonds' fixed coupon payment divided by its price. When interest rates decline, bond yields usually do too.

The latter scenario played out when the Federal Reserve began aggressively raising interest rates in 2022 and 2023. Bond yields rose as rates increased.

In September 2024, the Fed cut interest rates for the first time in four years. It followed up with rate cuts in November and December. Many investors might have naturally assumed that bond yields would fall, too.

However, an interesting thing happened with the U.S. 10-year Treasury yield, which is used as a benchmark for many loans. Instead of declining as interest rates fell, this widely followed yield has risen.

Data source: YCharts.

A potential warning signal for stocks

Why would the U.S. 10-year Treasury yield rise as the Fed cut interest rates? Bond investors look at several other factors in addition to interest rates. And they could appear to be concerned about potential trouble on the horizon.

Perhaps the biggest worry is that inflation could roar back. A second Trump administration could impose steep universal tariffs of up to 20%, and even higher tariffs on products imported from some countries, which many economists predict will lead to higher inflation. The prospects of major corporate tax cuts and mass deportations of undocumented immigrants could also be inflationary.

Higher inflation wouldn't be good news for many stocks. For example, consumers are less likely to spend when prices are higher. This negatively impacts the sales and profits of retailers.

The Fed would also almost certainly halt any further interest rate cuts with resurging inflation. It has already hinted that fewer rate cuts than initially anticipated will be made in 2025. The bond market could reflect fears that interest rates won't be reduced from current levels at all. The stock market's momentum might not be able to continue if no more rate cuts are in store.

There's another less obvious potential warning signal from the bond market. The S&P 500's earnings yield is at its lowest level relative to U.S. Treasury yields since 2002. A big gap exists between this earnings yield and BBB-rated corporate bonds as well. Both point to a historically expensive stock market that could be poised to fall with any significant bump in the road.

What should investors do?

If you're an income investor, all this could be welcome news. Higher bond yields could boost your income. If stocks fall, you'll be able to invest and lock in higher dividend yields.

But what should other investors do? The best answer is to think long-term.

The bond market may be sending a serious warning signal about the stock market. Even if that's the case, though, the signal would only be for the near term. Bond investors aren't so savvy that they know how bonds or stocks will perform over the next five to 10 years. Over the long term, stocks typically perform well.

That said, investors should probably focus on valuation and strong growth prospects even more than they might if the bond market weren't flashing any warning signs. If the stock market does pull back sharply, it's better to own stocks that were already attractively priced. And if bond investors' concerns prove to be unfounded, you'll still own stocks with plenty of room to run.

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Keith Speights has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.