Why the bond market is throwing a tantrum that could tank stocks
Reuters
- US Treasury yields hit the highest level since October 2023 this week.
- Strong economic data has dimmed rate cut views.
- Trump's economic plans are also causing markets to worry about the potential for inflation to spike again.
US Treasury yields are surging toward their highest level since October 2023, inching closer to a key threshold that's historically triggered a sell-off in stocks.
Behind the rise are fears that inflation is about to rear its head again, with the economy still hot after two years of rate hikes from the Federal Reserve, and Donald Trump's economic plans potentially stoking a fresh surge in prices.
The run-up is stoking fears reminiscent of other recent surges in bond yields. The collapse in the price of the 10-year Treasury and the jump to 5% yields in October 2023 marked one of the worst market crashes ever and was accompanied by a brutal sell-off in the stock market.
The 10-year US Treasury yield hit 4.73% on Wednesday and is marching toward the key 5% resistance level. The yield has edged up consistently since the Fed began cutting rates, diverging from the federal funds rate as bond markets predict higher rates in the face of stubborn inflation.
The release of December ISM services data on Tuesday came in at 54.1%, well above economist estimates of 53.2%. Within the ISM report, the prices-paid index surged to 64.4 from 58.2 in November, representing its highest reading since February 2023.
The update sent Treasury yields soaring early this week.
"The Bond Vigilantes aren't buying the Fed's esoteric narrative that the federal funds rate needs to be cut because the so-called neutral rate of interest is much lower than the prevailing 4.33%," Yardeni explained.
"What matters more to them is that inflation in the core services components of the CPI and PCED remains sticky well above 2.0%," he added.
Additionally, November job openings of 8.1 million were well above economist estimates of 7.7 million.
While strong economic data is typically good news for the stock market, that's not the case when it limits the Fed's ability to cut interest rates.
"With the 10-yr firmly above 4.5%, we believe the market is shifting into a 'good news is bad news' environment again," Ohsung Kwon, strategist at Bank of America, said in a recent note.
Analysts at Goldman Sachs also noted the correlation change between the stock market and bond yields.
"Equity/bond yield correlations have turned negative again," Goldman's Christian Mueller-Glissmann wrote in a note this week, adding that stock prices have further room to fall if yields move higher.
Following Tuesday's strong economic data, the probability of Fed interest rate cuts in 2025 dipped from two to one. Just a few weeks ago, the market had been expecting three or four interest rate cuts this year
The next economic data point that will have a big impact on bond yields is the December jobs report, which will be released on Friday morning.
Economists expect 155,000 jobs were added to the economy last month. A strong employment number above economist expectations could spark a tantrum that sends stock prices lower and bond yields higher.
BofA's Kwon expects the data to show 175,000 jobs were added last month. While that would be good news for the economy, the stock market could balk at such a strong reading.
"If rates see another jump on a strong NFP print this Friday, we believe the rate pressure could become a bigger headwind to equities than the tailwind from a good economy," Kwon said.
The final piece of the puzzle that's kept yield elevated is President-elect Donald Trump's economic and legislative proposals, which investors fear will be a catalyst for a fresh bout of inflation.
Trump has threatened wide-ranging tariffs against both allies and adversaries, and has also proposed "one big, beautiful bill" that would enact his agenda, which includes potential tax cuts.
On Wednesday, CNN reported that Trump is considering using emergency powers to enact his tariff plans. Stocks slipped and yields edged up early in Wednesday's trading session on the news.
Furthermore, the combination of tax cuts and high government spending could fuel a bigger deficit, which would also put upward pressure on Treasury yields.
Investors' anticipation of further fiscal spending under a Trump administration could be part of the reason why Treasury yields have surged 100 basis points while the Fed cut interest rates by 100 basis points.
"This is highly unusual," Torsten Slok, economist at Apollo, said in a note on Tuesday. "The market is telling us something, and it is very important for investors to have a view on why long rates are going up when the Fed is cutting."
From a technical perspective, Katie Stockton of Fairlead Strategies said the 10-year Treasury yield is bumping up against resistance at 4.70% and 5%.
"There are signs of short-term upside exhaustion, but they would be minimized by a decisive breakout," Stockton said in a note on Wednesday.