The U.S. economy’s three-body problem

December’s surprisingly strong jobs report has reignited concerns about the U.S. economy’s trajectory. Is this a sign that the economy risks reaccelerating and overheating? What does this mean for the Federal Reserve’s plans for monetary policy in 2025, and for investors? 

Let’s look deeper into those labor market numbers. The U.S. added 256,000 jobs in December, 92,000 above expectations. Education and Health services as well as Leisure & Hospitality were the primary drivers of service sector payroll growth, contributing 75% of gains. Additionally, government hiring has remained steady. 

Inflation data adds another layer to the narrative. January’s headline CPI rose to 2.9% year on year, up from December, while core CPI surprised to the downside at 3.2%. This mixed inflation picture may reassure some investors wary of aggressive Fed actions, particularly as the central bank is only expected to cut rates once in 2025. However, the uptick in headline inflation underscores lingering price pressures. 

The third and perhaps most critical factor at play is the Treasury curve, which has shifted to reflect the combined effects of stronger economic growth, higher inflation, and fiscal challenges. Going into the first Fed rate cut in mid-September, the curve underwent a bull steepening, with front-end yields falling and long-end yields rising, leading to the 2s10s curve uninverting after a record two years of inversion. 

Recently, however, a shift to bear steepening has emerged, with long-term yields climbing faster than short-term yields—and the 10-year Treasury yield remaining stubbornly near its 3Q23 (and 20-year) highs despite the 100 bp of Fed cuts last quarter. This rebalancing of risk from the short term to the longer term reflects the economy’s current solid economic growth supported by nonfarm payroll strength and corporate earnings, balanced by inflation pressures shaped by rising expectations, and medium-term fiscal concerns tied to incoming policies and debt dynamics. Higher long-term yields also serve to tap the brakes on the economy, acting as a drag on everything from mortgage lending to corporate borrowing. 

Against this backdrop, we maintain our overweight position in U.S. equities, particularly domestic large caps, as they are well positioned to benefit from resilient economic growth and corporate profitability. At the same time, bonds are becoming increasingly attractive, with yields approaching stretched levels and less correlation to equities. This underscores a potential return to bonds’ traditional role as an appealing diversification opportunity against equity volatility. Balancing these exposures will be critical as markets navigate a complex interplay of growth, inflation, and policy uncertainty. 

Arjun Kaushik contributed to this article.