Despite the market optimism surrounding the election of Donald Trump as president, 2025 could be the year US exceptionalism breaks, led by bear steepening in US treasury markets, according to BNY.
In its iFlow data, BNY noted that including its ‘Mood index’ data on equities, shorts, bond duration and cross-border flows, all point to a significant risk of reversals in the US dollar, US bond duration and US equities this year.
The is a huge reversal on 2024 and against the grain of the current consensus of the US investor outlook.
“US exceptionalism is at risk of ending, driven by bear steepening in US treasury markets. This dynamic reflects structural shifts in fixed income markets, fiscal policy pressures, and reduced cross-border demand for US debt,” BNY said.
Putting this in context, unlike the 1980s, when higher rates attracted cross-border buyers, the current US debt supply increases yield pressures without equivalent demand.
The revealing part is the positive correlation of bond and equity flows which reached a three-year high of more than 0.80% – which in the past has usually been followed by economic and market volatility.
“Correlations between stocks and bonds in a world with US 10-year bonds yielding 5% led by curve steepening and pauses by the Federal Reserve and the moderating impact of a 5% rise in the S&P 500 could serve as a ‘speed bump’,” BNY said.
This reflects the volatile split between share value and growth as investors are forced to rethink, especially on the magnificent seven set of stocks, the report added.
Market decline
In a worst-case scenario in the year ahead, BNY observes a decline by the S&P 500 of 10% to 20%, an end to US exceptionalism, US rates jumping higher on concerns about fiscal policy and doubts about US debt.
On this outlook, the US will likely be most aggressive with its tariff policy against China and possibly Mexico and Europe, with trade tariffs slowing global growth and boosting inflation.
BNY therefore said that the markets this year are expected to be more volatile than in 2024 and likely to provide less return for the risks, particularly in equities in the US, which is a solidly contrarian point.
“The US exceptionalism trade and the Trump tariff policy mix look incompatible,” the iFlows report said, so something has got to give.
The US 2 to 10-year curve has steepened from -30 basis points to +30, and historical trends suggest further steepening toward 75 basis points, signalling potential turbulence for US bonds.
Equity correction
When it comes to US equities, BNY said that they are overvalued relative to global peers and face a “high risk of correction” as portfolio rebalancing and stretched valuations put pressure on continued outperformance.
“US equity holdings are above long-term averages, with a strong likelihood of rebalancing in 2025 as investors diversify,” according to the iFlow study.
US equities account for 70% of global market capitalisation but only 27% of global GDP in 2024, underscoring their over-representation.
When it comes to the US dollar, it is now at a record high in real terms. Due to favorable inflation differentials and gains, the dollar ended 2024 more than 4% above its 2001 peak.
The effect of a stronger dollar on US imports, inflation and foreign revenues of US companies isn’t fully reflected in exchange rates, but that should change in 2025, BNY said.
As 29% of S&P 500 earnings are international and 60% are in currencies other than the US dollar, which could weaken on the selling of US equities, BNY added.
Potential shift
In contrast, Europe and Asia-Pacific (APAC) equity holdings remain “below their five-year averages”, highlighting potential for a shift in allocation away from US markets toward undervalued regions.
Short positioning in Europe and Asia is at Q4 2024 highs, indicating room for reversals, while iFlow Mood data shows improving sentiment for APAC and EU equities.
US short-term bill purchases also point to a cautious rotation out of risk assets. Therefore, Europe is well-positioned to out- perform, with equities leading the recovery and foreign exchange gains likely to follow.
The Stoxx 600 – made up of companies across Europe – forward price earnings ratio at 12.24 for 2026 is the lowest in 15 years, signalling deep under-valuation. European equities offer a dividend yield nearing 4%, compared to 1.4% for the S&P 500, enhancing their relative attractiveness.
Additionally, extreme euro short positioning and a weak currency provide a foundation for foreign exchange gains as sentiment improves, according to the iFlows report.
When it comes to China it is entering a ‘three arrows’ moment, marked by the convergence of fiscal, monetary and structural policy efforts to stabilise its economy, BNY said.
“This shift is poised to drive significant opportunities in fixed income, equities, and diversification flows across the APAC region,” the study said.
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