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The stock market is getting the jitters as this bearish signal flashes red again. Here's why the surge in bond yields is spooking the bulls.

Mar 3, 2023, 00:00 IST
Business Insider
The US dollar hit 20-year highs this year.NiseriN/Getty Images
  • The bond market is capturing a shift higher in interest-rate expectations, which is bad news for stocks.
  • The yield on the 10-year Treasury note breached 4% this week for the first time since November.
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The stock market is fast losing any remnants of its early-year bullish mood, with more evidence suggesting the twin threats of elevated inflation and higher interest rates are very much alive.

Underscoring such risks are the latest developments in the US bond market, which tends to capture the outlook for consumer-price trends and rates much more dynamically.

The yield on the 10-year Treasury note broke above the much-watched level of 4% this week, for the first time since November. And it is a clear signal that financial markets are abandoning any notion that the Federal Reserve may stop raising rates or even start cutting them later this year.

The latest bond-market warning signal is serving as a firm reminder to investors that the dismal trends that defined 2022, when a rout across stock and debt markets wrecked investor confidence, are far from over.

And high bond yields may be here to stay, according to billionaire investors such as Bill Gross and Jeffrey Gundlach. The rate on 10-year Treasuries has climbed by almost 60 basis points since the end of January, in a sign that the market is bracing for tougher Fed policy.

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Why yields are rising and what it means for stocks

The bond market is seen as the best barometer for investors' outlook for inflation and interest rates, and the recent ups and downs in yields essentially capture how those expectations have evolved.

For instance, bond rates saw a sharp pullback in January with investors presuming the Fed's hardest battles with inflation were over following last year's interest-rate increases. That coincided with a strong rebound in riskier assets such as stocks - an easing outlook for rates tends to support equities as lower borrowing costs are good for companies' finances and valuations.

At the start of February, the 10-year Treasury bond yield fell toward the lowest level since September, signaling investor optimism that the Fed will pivot from its aggressive policy stance amid predictions for an economic downturn.

But those hopes have since been dashed by a wave of surprisingly strong economic data, including a set of robust labor-market numbers, which have investors worried the Fed will need to keep raising rates to rein in inflation.

And this change of sentiment is basically what's reflected by the latest jump in bond yields, which has corresponded with declines in stocks. The NASDAQ Composite has declined more than 7% from a February 2 peak, while the S&P 500 lost almost 6%.

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What's next for bond yields?

The immediate reaction from major investors to 10-year bond rates breaching 4% suggested they expect yields remain elevated or head even higher - which would be bad news for stocks and other risky assets.

Billionaire investor Bill Gross, often known as the 'Bond King', thinks US yields are still too low. The co-founder of PIMCO tweeted that based on long-term averages, the gap between 10-year Treasury notes and the federal funds rate was currently too narrow, suggesting the bond was likely to settle around 4.5%.

"Now three handle Treasury interest rates are an endangered species," billionaire investor Jeffrey Gundlach said in a tweet Wednesday, suggesting bond rates below 4% is becoming a rarity.

Last week Gundlach told Yahoo Finance that the US was heading for a recession, brushing aside the debate between a "hard" or "soft landing" for the economy in the process.

In an opinion piece for Bloomberg Thursday, famed economist Mohamed El-Erian said recent economic developments should leave investors wary of more aggressive rate moves by the Fed.

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"It is often said that the first rule of finding yourself in a hole is to stop digging. With the Fed having already dug itself a deep hole, it is no longer crystal clear to me what the right policy step should be now," El-Erian wrote. "I suspect I am not the only one."

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