And the most important variable for stock performance in January is — drumroll — rates.
That’s according to Morgan Stanley’s Mike Wilson who, in his first massive of the new year, noted that the equity-rate correlation recently flipped negative again, which is to say if yields are rising, stocks are falling.
Remember how this works: Stocks can digest higher bond yields if they (yields) are rising for the “right” reasons, where that means growth expectations (or growth outcomes) are improving.
If, on the other hand, yields are rising on rekindled price pressures in an inflationary environment (as distinct from reflation “green shoots” in a disinflationary environment like that which persisted across the Western world post-GFC and pre-pandemic), hawkish monetary policy and/or concerns around fiscal profligacy, stocks may have a harder time countenancing higher long-end rates.
The bond selloff witnessed over the last several weeks is the kind equities often struggle with, particularly in the presence of a wider term premium which suggests “this is not a drill,” so to speak, re: fiscal fretting. On Monday, 30-year US yields rose to the highest since November of 2023.
“In early December, we highlighted that 4.00%-4.50% on the 10-year yield was likely the sweet spot for equity multiples [as] we thought that a break above that threshold driven by either less dovish monetary policy expectations or a rise in the term premium would likely serve as a headwind for multiples as it did in April of 2024,” Wilson remarked. “Recently, these drivers have pushed the 10-year yield above 4.50% and the correlation of equity returns to bond yields has flipped decisively into negative territory, something we have not seen since last summer,” he added.
The figures above, from Wilson’s note, illustrate the point: Stocks are running out of patience with this particular bond selloff.
For what it’s worth, this discussion played prominently in the latest Weekly, which you can read here if you didn’t catch it on Saturday.
As alluded to above, this wouldn’t be as problematic for equities if the US economy were still surprising to the upside, but it isn’t. Not relative to economists’ forecasts, anyway, and that matters whether it should or not.
The figure on the right, above, shows Bloomberg’s US economic surprise gauge rolling over, even as yields continue to trek higher. That’s suboptimal, to put it politely.
As Wilson went on to note, “there may be some reflexivity to the movement in the economic surprise index, meaning that the rise in rates over the past several months may just recently have started to weigh on economic activity.”
Indeed, and that’s something the incoming Trump administration needs to internalize. Higher bond yields don’t just happen in a vacuum, and Trump’s policy platform is at least in part responsible for the term premium rebuild since the election.
“In order to see the return of a ‘good is good’ backdrop where hotter economic data drives upside in stocks even amid higher rates, we likely need to see more convincing evidence that animal spirits are inflecting and translating into stronger economic activity,” Wilson said, adding that “stickier inflation readings in the absence of this dynamic on the growth front would likely keep equity return/bond yield correlations negative.”
