The yield on the ten-year US Treasury bond was trading just below 4.8% on Friday. Apart from a temporary spike in October 2023, it is the highest level since 2007. In just one month, the ten-year yield has surged by almost 70 basis points.
Similar increases in the past have led to a 19% plunge in the S&P 500 index in 2022. The stock market also saw declines in the fall of 2023 and April 2024 following rising interest rates. On Wall Street, warning flags are now being raised about a potential repricing.
Morgan Stanley’s chief strategist, Michael Wilson, stated this week that bond yields are “the most important variable” to watch at the beginning of 2025. He is supported by Handelsbanken’s chief strategist, Mattias Sundling.
“The first thing I look at every morning is the US ten-year yield. It is the ‘price of prices’ that one should never ignore. If something happens in the ten-year, you know that something significant has occurred,” said Sundling.
Sundling emphasized that the connection between the ten-year yield and stocks is complex. Sometimes, rising bond yields cause stocks to fall, but during other periods, asset classes move in the same direction.
Michael Wilson believes that a shift has occurred in the past month, where rising rates are once again making the stock market nervous. The US small-cap Russell 2000 index has dropped by 7% in the last month, while the broad S&P 500 is down by nearly 3%.
Sundling sees two possible explanations for the recent surge in yields. It could partly be due to the market pricing in higher inflation and tighter monetary policy from the Federal Reserve. If so, the market turmoil is likely to be short-lived. In the long run, extended inflation pressure would be positive for the stock market.
“The market likes inflation. Not too much, but just right. Look at how companies’ profits have skyrocketed thanks to price increases,” he said.
The second possible explanation would be “unequivocally negative” for the market, according to Sundling. It involves investors demanding compensation for increased risk in US treasuries ahead of Donald Trump’s presidency. Some analysts have referred to it as an “idiot premium.”
“The US has already put the pedal to the metal under Biden and pursued extreme fiscal policies. If you’re looking for a period with a similar level of national debt and budget deficits, you have to go back to World War II. There is concern that Trump will further increase budget deficits,” Sundling explained.
A crucial question is at what level the ten-year yield would seriously impact the stock market. Analysts at ING and T. Rowe Price predict that the bond yield will surpass the key level of 5% in the first quarter. There is a fear that it could trigger a massive shift of capital from stocks to bonds. The theory is that the bond yield would simply become too attractive to resist.
“People say that flows will start to move at 5%. Maybe that’s true, I don’t know. But I would be cautious about setting such a limit,” Sundling cautioned.
“How would it affect the Stockholm Stock Exchange if there is a serious interest rate frenzy on Wall Street?”
“The correlation between US and Swedish stocks is high.”
Sundling also highlighted a potential wildcard that could radically change the outlook: Elon Musk.
As the head of the newly established Department of Government Efficiency (DOGE), Musk has expressed an ambition to reduce US federal spending by up to $2 trillion. If successful, it could alleviate the bond market’s concerns about budget deficits.
“Say what you will about Musk, but he gets things done. If he manages to cut by $500 billion, it would be unprecedented and effectively entail fiscal tightening,” Sundling concluded.