It's no secret that Treasury yields have a significant impact on the stock market. In fact, soaring yields were largely blamed for the recent selloff that sent the S&P 500 into correction territory.
However, last week brought a turnaround. Yields on 10-year Treasury notes (BX:TMUBMUSD10Y) and 30-year Treasury bonds (BX:TMUBMUSD30Y) experienced their biggest drop since March. This sudden decrease in yields led to a surge in stocks, resulting in the S&P 500, Dow Jones Industrial Average, and Nasdaq Composite logging their largest weekly gains of 2023.
As of Friday, the S&P 500 closed at 4,358.34.
Now, the question remains: Can a definitive top in yields signal a resumption of the 2023 rally for stocks?
The answer isn't straightforward and depends on various factors.
According to analysts at U.K.-based Matrix Trade, yields could peak for several reasons, but not all of them would be favorable for stocks. They suggest that a bullish scenario for stocks would involve a strong economy accompanied by a drop in inflation to levels that would allow the Federal Reserve to cut interest rates without triggering a secondary wave of inflation reminiscent of the 1970s. While they don't consider this scenario highly likely, they acknowledge that it could still occur as long as unemployment doesn't experience a significant spike.
Conversely, if a recession were to occur, it could lead to both yields and stocks moving lower simultaneously, similar to what was observed during the periods of 2000-2002 and 2007-2009.
Overall, the relationship between Treasury yields and the stock market is complex and heavily influenced by the prevailing economic conditions.
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See: Skeptics Cast Doubt on the Recent Dow Rally, But What's Behind Their Lack of Conviction?
Economists Surprised by Resilient Economy
Economists have been surprised by the resilience of the economy this year. Initially, many experts predicted a recession by 2023, but their predictions changed in July or August when the S&P 500 reached its peak for the year.
The Challenge of Timing
One of the difficulties economists face is the unpredictable timing of recession indicators. The inversion of the yield curve, where short-term yields exceed long-term yields, is typically considered a reliable precursor to a recession. However, the timing of this signal is uncertain.
Fine-Tuning the Signal
Analysts from Matrix Trade propose refining this signal by combining it with unemployment claims. They anticipate that when first-time claims surpass 250,000, it will be a clear indication that a recession is imminent.
Softening Labor Market
In the week ending October 28, the number of Americans filing for first-time unemployment benefits rose by 5,000 to a seven-week high of 217,000, according to the Labor Department's report on November 2. This suggests a slight weakening in the U.S. labor market, although its impact on the stock market remains unclear.
Identifying Yield Peaks
The Matrix analysts argue that determining when yields have reached their highest point is relatively easier compared to predicting stock market trends. They highlight the 4.33%-4.43% range as a critical inflection point for the 10-year Treasury note. If this range holds, the 10-year yield could rise above 5%. However, if it breaks, indicating a shift in direction, the analysts believe the current rally will come to an end.
A Broader Correction
Should a broader correction occur, driving the 10-year yield back to 2.5% to 3%, the economy is likely to face significant pressure. The analysts suggest that such low yields are usually associated with a recession, making it an unlikely scenario without an economic downturn.
Challenging the Euphoric Rally
Considering the interplay between stocks and yields, the Matrix analysts predict that the current bullish rally will not continue into the next bull market. They expect that the stock market's level of 4,103 will be once again challenged early next year, dampening overall optimism.
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