Why Treasurys could give the U.S. stock market a green light for a year-end

Back in September a bond market selloff was fueled by a hawkish outlook from the Federal Reserve, along with mounting concern about the U.S. fiscal deficit and federal debt amid the potential for a government shutdown if a budget for the 2024 fiscal year is not settled by mid-November.

Earlier this week though, increased uncertainty about the conflict in the Middle East propelled demand for safer assets and caused longer-term bond prices to jump and their yields to fall.

Then, on Thursday, a Treasury bond auction which saw a pullback in demand despite notably higher yields, sent longer-term rates higher again while investors were already digesting inflation data that showed consumer prices remained elevated in September. The U.S. stocks fell and booked their worst day in five sessions on Thursday. 

Investors are now wondering what it will take for interest rates and bond yields to fall in the months ahead and whether a retreat in yields could eventually push stocks higher to rally into the year-end. 

Tim Hayes, chief global investment strategist at Ned Davis Research, said “excessive pessimism” in the bond market is setting up for a relief rally both in stock and bond prices as “there’s not as much inflationary pressures as the market has been pricing in,” he told MarketWatch in a phone interview on Thursday.

Hayes said his team found the bond sentiment data has started to reflect a “decisive reversal” away from too much pessimism in the Treasury market which could send bond yields lower and boost equities given the inverse correlations between the S&P 500
SPX
and the 10-year Treasury note yield
BX:TMUBMUSD10Y.

See: Here is what needs to happen for the S&P 500 to hold on to this year’s gains

Meanwhile, some analysts said disinflation may not be enough for the Federal Reserve to drop its “higher-for-longer” interest rate narrative which was primarily responsible for the big spike in yields since September. 

The economy needs a slowdown in the consumer sector for some relaxation in the Fed’s “higher-for-longer” narrative and to maybe push policymakers to adopt a more flexible outlook for its long-term guidance, said Thierry Wizman, global FX and interest rates strategist at Macquarie. 

“Of course, the Fed right now is certainly not saying anything that’s remotely suggestive of ‘high-for-long’ being taken away or being removed or negated, so I don’t expect yields to fall a lot unless we start to get reasons to believe the Fed is going to remove that narrative based on the economic data,” Wizman told MarketWatch via phone. 

However, Wizman said he is confident that the U.S. consumption data will weaken over the next few months when major consumer-product and -service companies start to provide guidance for the fourth quarter, and when U.S. consumers, which have been trapped in a web of conflicting signals on the health of the economy, open their wallet for the holiday shopping season. 

“This will produce some weakness on the consumer side of the market and there’s no doubt the slowdown will be more pronounced than most people expect in the economy, [but] that will be the positive scenario for bonds,” said Marco Pirondini, head of U.S. equities at Amundi U.S., in an interview with MarketWatch. 

However, that also means investors should not be “too anxious to buy dips in the stock market” because it would be very unusual if the stock market doesn’t see “multiple compression” with Treasury yields at 16-year highs, Wizman said. “Stocks would still look too rich even if the Fed drops the ‘higher-for-longer’ narrative in the first quarter of 2024.”

See: Fed skips rate hike for now, but doesn’t rule out another increase this year

The “higher-for-longer” mantra is an idea Fed officials have tried to get the market to absorb in recent months, with Fed Chair Powell hardening his rhetoric at the September FOMC meeting, pointing potentially to more rate hikes or, more importantly, interest rates that stay higher for longer.

Fed officials saw…