Bonds Driving the Stock Market Bus

The stock market opened higher this morning (Dow +100 points; S&P 500 +.6%) in response to falling bond yields & oil prices. The 10-year Treasury yield ticked down to 4.7% and WTI crude oil fell back under $88/barrel.

As I’ve noted in recent updates, long-term bond yields have been rising steadily. The 10-year Treasury Note yield is up around 4.7% from 3.9% at the beginning of the year. Why? First, much higher government spending deficits have to be financed and that means issuing a lot more Treasury bonds. Second, part of the Federal Reserve’s plan to tighten financial conditions includes reducing the size of its balance sheet. And that means gradually and systematically selling Treasuries. Finally, I think traders are less jittery about the chance of an immediate recession scenario. Positive economic data surprises have become the norm in 2023. So altogether, we’re seeing higher supply of bonds without a boost in demand.

Unfortunately, rising rates are pressuring the stock market and many Wall Street strategists are saying stocks won’t turn around until rates stop going up. We might be close to that point where rates stabilize. There’s an old saw that says the 10-year Treasury yield should be about equal to nominal GDP growth. In other words, if the economy is growing at 2% and inflation is at 2.5% to 3%, the 10-year should yield somewhere between 4.5% and 5%. Again, we’re probably close to a near-term top in yields.

Setting aside this notion that bond yields are driving the stock market bus for a moment, let’s consider other factors. First, over the past 40 years the S&P 500 is up 80% of the time during the fourth quarter. We could get a seasonal uplift. Second, let’s not forget that corporate earnings expectations are much improved. Earnings per share among S&P 500 companies, which suffered through four straight quarters of negative growth, are now poised to rebound. In fact, the consensus of Wall Street analysts is for 11%+ earnings growth next year. And third, the stock market has pulled back over the last two months, making it much harder to argue that stocks are overvalued.