The S&P 500 (SNPINDEX: ^GSPC) has added 9% year to date despite geopolitical tensions in the Middle East. But the bond market is flashing a warning that could mean trouble for the stock market.
Treasury bond yields have risen dramatically in recent months because investors expect the Federal Reserve to raise interest rates to fight inflation tied to the U.S.-Iran war. Since 1999, the S&P 500 has always declined following the onset of a new rate-hike cycle.
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Here are the important details.
Bond prices and yields move in opposite directions
Treasury bonds are debt securities issued by the government. Bondholders essentially loan the government money in exchange for fixed interest payments (called coupon payments). They also recoup the principle investment when the bond reaches maturity.
Importantly, while interest payments are fixed, a bond’s market value can increase or decrease based on demand. In turn, the yield — the coupon payment divided by the bond’s market value — can change. Bond prices and yields move in opposite directions.
Bond prices generally fall (causing yields to rise) during periods of high inflation because investors expect the Federal Reserve to raise its benchmark interest rate (the federal funds rate). When that rate increases, banks pay more to borrow money overnight. They pass those costs to businesses and consumers, triggering a chain reaction that pushes bond yields higher.
Treasury yields are rising because the market expects the Federal Reserve to raise rates
The Iran war has stopped ships from crossing the Strait of Hormuz, a critical oil transit route in the Persian Gulf. Consequently, oil prices have surged to a multiyear high, and consumer prices are increasing rapidly. CPI inflation accelerated to 3.8% in April, a level last seen in 2023.
That figure is likely to increase further in the months ahead as high energy prices put inflationary pressure on other parts of the economy by driving up manufacturing and transportation costs. A forecasting tool from the Federal Reserve Bank of Cleveland shows CPI inflation accelerating to 6.7% in the second quarter.
Treasury yields have increased across the yield curve since the Iran war started in late February as detailed below:
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1-year Treasury bill pays 3.86%, up 38 basis points.
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2-year Treasury note pays 4.13%, up 75 basis points.
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10-year Treasury note pays 4.56%, up 59 basis points.
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20-year Treasury bond pays 5.06%, up 49 basis points.
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30-year Treasury bond pays 5.07%, up 43 basis points.
