The Bond Market Sounds an Alarm. The Stock Market Will Make a Big Move if History Repeats.
Key Points
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Treasury bond yields have increased substantially due to concerns about inflation, the national debt, and growing corporate bond supply.
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The 10-year Treasury bond yielded more than 5% when the market closed on Sept. 18, marking the highest payout in nearly two decades.
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Last time the 10-year Treasury yield was over 5%, the S&P 500 and Nasdaq Composite dropped more than 20% in the next year.
The U.S. stock market is having another good year. The S&P 500(SNPINDEX:^GSPC) has advanced 13% and the Nasdaq Composite(NASDAQINDEX:^IXIC) has added 16% amid strong corporate earnings growth, especially in the technology sector.
However, the bond market is sounding an alarm for the first time in nearly two decades — Treasury yields have reached levels last seen in 2007 — and it hints at a potential downturn in the stock market.
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Treasury bond prices and yields move in opposite directions
U.S. Treasury bonds are debt securities issued by the federal government. When investors buy Treasuries, they are essentially lending money to the government in exchange for fixed interest payments and the return of the principal when the bond matures.
Bond coupon rates are fixed at issuance, but yields can fluctuate. For instance, a $1,000 10-year Treasury bond with an annual coupon of $40 has a yield of 4%. The coupon payment will always be $40, but the yield will change based on what investors are willing to pay for the bond, which is determined by supply and demand.
If demand increases, buying pressure could drive the price of the bond to $1,100, in which case the yield would decline to 3.6% (i.e., $40 divided by $1,100). Alternatively, if demand decreases, selling pressure could drag the price of the bond to $900, in which case the yield would increase to 4.4%.
Treasury yields are soaring due to inflation, the national debt, and AI spending
The Treasury yield curve has become steeper in recent months, meaning yields at the long end (i.e., bonds with maturities of 10 years to 30 years) have increased faster than yields at the short end. There are several reasons for that trend.
First, inflation has now exceeded the Federal Reserve’s 2% target for more than five years, and the Trump administration has contributed to the problem with tariffs and military action in Iran. In turn, investors have sold bonds (driving yields up) because they expect higher future interest rates as the Fed battles inflation.
Second, the national debt recently reached $40 trillion, and that figure will probably keep climbing because the federal government regularly runs deficits. That means the Treasury will have to issue more bonds to finance future budget shortfalls. So, investors have sold Treasuries because they expect prices to fall as supply increases.
Third, companies are taking on debt to finance investments in artificial intelligence (AI) infrastructure; capex spending among the top five hyperscalers alone is projected to total $800 billion this year. Investors have sold Treasuries because they expect prices to decline as the growing corporate bond supply creates competition for capital.
Soaring Treasury yields have become a threat to the stock market
Each month, Bank of America surveys approximately 400 institutional investors and hedge fund managers to ascertain their thoughts on financial markets and the global economy. In the latest survey, fund managers ranked the disorderly rise in bond yields as the greatest risk to the stock market.
Indeed, the 10-year Treasury bond yielded more than 5% when the market closed on Sept. 18, representing the highest payout since July 2007. Last time the 10-year Treasury paid that much, the S&P 500 and Nasdaq fell sharply in the next year, declining 22% and 24%, respectively. The S&P 500 ultimately entered a deep bear market that erased over 50% of its value.
Of course, the economic backdrop in 2007 was somewhat different from what it is today. In both periods, high oil prices contributed to inflationary pressure that fueled expectations for interest rate hikes. However, the current situation is more nuanced, as investors are also focused on the national debt and a substantial supply of corporate bonds.
Additionally, the primary driver of the stock market’s steep decline between 2007 and 2009 was the collapse of the housing bubble, which triggered a prolonged recession. While the stock market faces other risks today, it would be presumptuous to assume the current situation will end in a devastating bear market.
Even so, high Treasury yields do pose a problem for stocks because they make bonds look more attractive relative to equities. Why pay for risky stocks when risk-free Treasuries offer decent returns? Also, higher borrowing costs can slow corporate earnings growth, putting pressure on stock prices because valuations are typically tied to forward earnings estimates.
Here’s the big picture: The stock market faces headwinds in rising interest rates and surging Treasury yields. No one can predict the future, but those hurdles could lead to a correction or even a bear market under the right circumstances.
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Bank of America is an advertising partner of Motley Fool Money. Trevor Jennewine has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
