By Despite robust stock prices, bond prices are experiencing a decline due to growing concerns about inflation. The Federal Reserve may need to extend high interest rates to control inflation, leading to rising bond yields and falling bond prices. This situation also has implications for stocks, but investors remain optimistic about the strengthening of corporate earnings in late 2023 and 2024.
The 10-year Treasury yield has recently climbed over 4% compared to around 3.7% at the end of June. The Fed’s efforts to moderate economic growth with a series of interest rate hikes last year have had limited success, as the labor market remains strong enough for additional rate hikes to be considered by the central bank.
The bond market, which experienced significant fluctuations during the Fed’s previous rate hikes, is once again becoming uneasy. The MOVE Index, which measures bond market volatility, has reached a level not seen in months.
What’s most alarming is that the bond market is indicating a further increase in inflation and the need for sustained high-interest rates. Inflation expectations for the next ten years, as reflected in the inflation swaps market, have risen to about 2.27% from roughly 2.18% in late June. Furthermore, the 10-year yield now stands approximately 1.75 percentage points above inflation expectations, up from around 1.53 points at the end of June. This growing disparity between bond yields and inflation expectations suggests that bond traders anticipate a continued upward trend in inflation expectations.
Rising Rates and the Stock Market
Despite rising rates, the S&P 500 stock index has experienced significant growth, surpassing a 20% increase since its bear market low in October. It has even posted a small gain since the end of June, despite the recent jumps in yields.
However, this upward trend in the stock market comes with growing risks. Continued damage to economic demand could potentially lower earnings, making the stock market even more expensive. Currently, the S&P 500’s forward price/earnings ratio stands at 19 times, resulting in a 5.2% earnings yield. This is only about 1.2 percentage points higher than the yield offered by the safe 10-year bond. Such a lower-than-normal risk premium for equities means that for stocks to thrive, one of two things must happen: either earnings must rapidly increase or rates must fall, or perhaps both.
Mike Wilson, chief U.S. equity strategist at Morgan Stanley, believes that the market is overlooking the near-term earnings recession, with optimism for strong growth in the second half of 2023 and 2024. On the other hand, Tom Essay from Sevens Report suggests that the stock market implies that rates are likely to decline from their current levels.
While there may be some validity to both predictions regarding future earnings and rates, the short-term journey is anticipated to be turbulent.
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