Analysts urge focus on ‘most important variables’ in stock market rebound

The bond market faces a major test early this week that could not only send yields sharply higher but also challenge investors’ optimism about stocks in the current bull market.

U.S. Treasury yields have moved significantly higher over the past month, with the benchmark 10-year Treasury yield rising to its highest level since May. Market moves reflected new inflation risks, hawkish signals from the Federal Reserve and concerns that President-elect Donald Trump’s incoming administration will add more debt to the nation’s staggering $36 trillion in debt.

In fact, Morgan Stanley analyst Mike Wilson said interest rate markets will be the “most important variable to watch” in the first few months of the year as stocks look to shake off their late-December slump and meet the bullish forecasts of Wall Street analysts.

“In early December, we highlighted that 10-year Treasury yields of 4%-4.5% may be the sweet spot for equity price-to-earnings ratios,” Wilson and his team wrote. But they now believe the correlation between the S&P 500 and Treasury yields is “clearly negative.”

That could prove to be a key driver of stock market moves this week as the Treasury Department prepares for three benchmark bond auctions worth about $119 billion in the coming days, including a focus on selling $39 billion of 10-year bonds.

Treasury investors eye job market data

Markets will also release four pieces of labor market data in the shortened trading week, with stocks closed Thursday for a day of mourning to mark the death of former President Jimmy Carter.

Key data came on Friday from the Labor Department’s December jobs report, which is expected to show the economy will end the year with 150,000 new workers and an overall unemployment rate of 4.2%.

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Bond markets will be watching the report closely, especially on wage growth, as inflationary pressures linger in an economy that continues to defy forecasts of a slowdown.

Inflation is often called the enemy of bonds because it erodes the present value of future coupon and principal payments, making them particularly sensitive to changes in forecasts.

When traders sell bonds amid accelerating inflation, yields rise, creating an attractive risk-free option for investors but also signaling potential headwinds for corporate profits and the broader economy.

The benchmark 10-year Treasury yield, the benchmark for risk-free rates in global financial markets, hit its highest level in eight months last week and has risen more than 50 basis points (0.5 percentage points) in December.

The last close on the note was 4.632%, a level that could signal near-term pressure on the stock market if it continues higher.

Stocks and Treasury bond yields are negatively correlated

Morgan Stanley’s Wilson also noted that yields rise when the breadth of the stock market or the number of stocks driving recent gains shrinks.

In November, he and his team expected the S&P 500 to stabilize around 6,500 by the end of the year, up 8% from current levels. Their optimistic forecast is that the benchmark 10-year Treasury yield will fall to 2.2%, pushing the index to 7,400 points.

To insulate the market from the risk of rising yields, more stocks need to improve their recent performance and the S&P 500 needs to become less reliant on large-cap tech stocks.

Wilson said this “will likely rely on a combination of lower interest rates, a weaker dollar, clarity on tariff policy/cabinet confirmations and stronger earnings revisions.”

Currently, data from the London Stock Exchange shows that the collective profit of the S&P 500 Index will rise to $275 per share this year, an increase of 14.2% from 2024, with technology stocks and financial stocks leading the recent gains.

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U.S. Treasury yields could also rise if the U.S. breaches its current debt ceiling ($31.4 trillion, but is set to be suspended in 2023 later this month).

“I would like to urge Congress to take action to protect the full confidence and credit of the United States,” Treasury Secretary Janet Yellen wrote in a letter last week.

US debt is the ‘elephant in the room’

So far, there’s been little sign of that: Trump has urged lawmakers to lift the debt ceiling entirely, while House Republicans have focused on a “one-bill” strategy for tax cuts, tariffs and immigration reform. The Committee for a Responsible Federal Budget estimates that the bill could add another $7.5 trillion to the national debt.

Rising U.S. debt levels are “the elephant in the room that could prevent interest rates from falling above ‘normal’ levels of inflation,” said Louis Navellier of Navellier Calculation Investments.

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“One guaranteed event is that there will be a rollover of huge government debt over the next two years, $7.6 trillion over 25 years, with much of that debt being replaced by higher coupon rates,” he said.

“With federal interest payments already exceeding a trillion dollars a year, this may be the biggest challenge and there are no easy solutions,” he added.

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