The Stock Market Is Playing a ‘Game of Chicken’ With Bonds. It Won’t End Well.

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In the post-Covid world, the stock market is supposed to go down when bond yields go up, but recently, stocks haven’t reacted much to the bond market. Something has to give. 

In roughly the past month, the

10-year Treasury

yield has risen to 3.77% from 3.37% on Jan. 18, the low for the year. Driving that has been stronger-than-expected economic data, which means the rate of inflation may decline at a fairly slow pace. More-persistent inflation means the Federal Reserve, which has been lifting interest rates to slow down the rise in prices by reducing demand for goods and services, is likely to keep on doing so.

In theory, the likelihood that higher rates would hurt economic growth should drag stocks lower. That has been the pattern over the past 18 months or so. The stock market has fallen when yields have risen in response to expectations for higher interest rates because investors have reasoned that the Fed’s approach meant slamming the brakes on the economy, rather than just taking away the punchbowl.

The fact that companies are seeing profit forecasts drop is evidence that the Fed is having some success, 

But the stock market has been stubborn recently. Since Jan. 18, the

S&P 500

is up almost 5%, even though bond yields have risen over the same span.

Valuations of stocks are following a similiarly odd pattern. Since early 2021, the S&P 500’s aggregate forward price/earnings ratio had been falling when the 10-year yield rose, according to Evercore. But for much of this year, the index’s multiple—the amount investors are willing to pay for the earnings the component companies produce—has risen even as yields have jumped.

The result, and the problem, is that the yield investors receive by owning the S&P 500 has now declined relative to the yield on the safe 10-year Treasury note.

The point is that the stock market appears to be making some aggressive assumptions that will derail the recent rally if they turn out to be wrong. This year’s trading action seems to indicate investors expect forecasts of corporate earnings will soon rise, which would mean stocks would yield more at current prices. Expectations that the 10-year yield will soon drop, making the yield on stocks more acceptable relative to that on Treasury debt, could also explain the S&P 500’s strength.

Both ways of looking at the market point to the same idea: The Fed may soon pause its rate increases, making the outlook for earnings more positive and allowing bond yields to fall.

That is well and good, unless it doesn’t happen because inflation doesn’t cooperate. 

“Either the stock market at current levels believes that this rate move higher won’t last or it’s delusional in thinking it’s ok at the same time an earnings recession has begun,” wrote Peter Boockvar, chief investment officer of Bleakley Advisory Group. “A game of chicken now between stocks and bonds?”

Things could get ugly again for stocks and bonds.

Write to Jacob Sonenshine at [email protected]