As stock markets navigate heightened volatility and rising bond yields in 2025, investors are reducing bets on interest rate cuts in the US and pricing in more potential inflation under a Donald Trump government, which could continue to weigh on stock markets, according to Damien Hennessy, Head of Asset Allocation with Zenith Investment Partners.

Given Donald Trump's pro-growth economic policies, financial markets are pricing in a higher underlying level of real yields and modestly higher inflation. Combined with inflationary factors and record levels of US debt, this has driven bond yields higher and produced more volatility within equity markets.

“Bond yields are rising because the US economy has been much stronger than expected, and the disinflation we have seen over the last 12 to 18 months in the US economy has run into headwinds. That is now starting to challenge US equity market valuations,” said Mr Hennessy.

“Looking back to September and the lows in bond yields, investors were predicting a high risk of recession in the US, and markets were betting on official interest rates falling to 2.8 per cent by early 2026. That number has lifted to about 4 per cent. Bond markets have gone from anticipating perhaps nine interest rate cuts, to possibly one or two more - that is quite a turnaround. 

“Investors are now asking themselves if they are being sufficiently compensated for the risk of investing in equities,” he said. 

US 10-year Treasury yields have climbed toward 4.8 per cent this year, a jump that has shaken US stock markets and hurt bond prices. The US dollar has also jumped, pushing the Australian dollar down towards US62 cents, from around US69 cents in September.

While some bond traders now believe the US Federal Reserve could pause interest rate cuts at its next monetary policy meeting scheduled for 28-29 January after Donald Trump enters the White House, Mr Hennessy isn’t sure inflation will reaccelerate as much as markets expect under a Trump government. 

“The market is pricing in a fair few of Trump’s policies being implemented quickly in 2025, and that economic growth will stay strong at about 2.8 per cent. However, we believe some of those expectations will be challenged and not all of Trump’s policies will be implemented as quickly as markets expect,” he said. 

This has improved valuations in the bond market, which would draw investors. 

“On balance, at close to 5 per cent, bonds start to look like reasonable value in a long-term sense and relatively attractive, so this could be an opportunity for investors to add bonds and duration to portfolios,” Mr Hennessy said.

“Up until now equity markets have largely ignored rising bond yields, but there comes a point at which rising bond yields challenge equity valuations.  Given that the extra risk premium from holding a broad index of equities compared to a bond has declined, investors need to be even more confident that earnings growth will be sustained.

“I expect that market concerns about high bond yields and how this impacts equity valuations will remain a focus for markets for most of 2025,” he said.

Regarding the Australian share market, Mr Hennessy expressed caution given a flat earnings outlook and relatively high equity valuations. While a potential cut in interest rates could boost investor sentiment, consumer and business confidence remain fragile, adding pressure to financial markets.

"Domestically, valuations are extended and it is an uphill battle for Australian equities. We don't have an overwhelmingly positive outlook. A rate cut could help sentiment somewhat, but the Australian share market is still pretty challenged," he said.