Markets were jolted early this week (especially AI oriented technology companies) as DeepSeek was recently revealed as an advanced AI research and development initiative focused on creating powerful language models and AI-driven tools. It is designed to compete with models like OpenAI’s GPT, Google’s Gemini, and Meta’s Llama. DeepSeek AI has developed various models, including DeepSeek-V2, which is a large language model with strong reasoning, coding, and comprehension capabilities. The claim to fame for this application is that in a world where AI development is usually a very expensive process, DeepSeek has achieved success at a fraction of the usual costs associated with AI development. The tech world is watching this story develop with great interest and it may portend accelerated AI developments which could positively impact our world sooner and in significant ways.

The outlook for the equity markets depends on several factors. On the positive side, corporate earnings continue to be strong and Consumer spending has remained resilient, despite inflation concerns. Also, the Federal Reserve’s (Fed) policies suggest a controlled slowdown without a significant recession. The Fed met this afternoon – leaving rates unchanged, but they have indicated possible rate cuts in 2025. Analyst consensus expects 2 – 3 rate cuts this year (equities like rate cuts because it lowers borrowing costs). But markets remain uncertain about timing. Additionally, oil prices are stabilizing and with the new administration aggressively pursuing more abundant American energy, prices may fall, decreasing inflation pressures.

Of concern is the Fed may not cut rates as aggressively as markets hope. Some analysts see the possibility of a deceleration in corporate profits and of course, there are always the geopolitical risks that raise tensions in global markets (e.g., China – Taiwan, Middle East, etc.)

Speaking of inflation, how worried are we? The Fed cut interest rates last September and, to date, the central bank has lowered rates by 1%. But over the same period, long-term Treasury yields are higher by 1% (per the 10-year Treasury yield). Does that mean bond investors are worried about inflationary pressures reigniting, particularly with tariffs and a pro-growth policy agenda under the new Trump presidency? Not yet at least. The bond market is expecting inflationary pressures to be higher than the low inflation regime experienced pre-COVID-19, but inflation expectations are not necessarily unanchored, which is good news for the Fed.

After enduring the most aggressive rate-hiking cycle in decades, fixed income investors were likely to think it would be an easy road to lower yields/higher prices once the Fed started cutting interest rates. Unfortunately, that hasn’t happened. In fact, the opposite happened. Since the Fed started cutting rates last September, the fed funds rate is lower by 1%, but at the same time, the 10-year Treasury yield is higher by nearly 1%. Only in 1981, at the height of the highest inflationary pressures ever here in the U.S., did the 10-year yield move higher than the recent move during a Fed rate-cutting campaign. During rate-cutting campaigns, long-term yields tend to drop — not rise. Reasons behind the move are plentiful, with more resilient economic growth, concerns about inflation, and Treasury supply/demand dynamics all reasons why Treasury yields are higher. But looking at what markets are pricing on for inflation risks, inflation reigniting is only contributing roughly a third of the move higher in interest rates, with non-inflationary reasons contributing the rest.

– Mark and Elise

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