Morgan Stanley chief U.S. equity strategist Mike Wilson said the bond market's recent volatility is effectively carrying out part of the Federal Reserve's tightening job, creating a different framework for reading where stocks could go next.
In his latest weekly note, Wilson said U.S. financial conditions have tightened sharply as the 10-year Treasury yield has climbed 120 basis points since February. In his view, the bond market is, in practice, doing some of the Fed's rate-hiking work, which could reduce the need for further increases in the policy rate. If Wednesday's U.S. Consumer Price Index, or CPI, comes in tame, pressure on long-dated yields and market expectations for policy rates could ease.
Bond moves are already transmitting tighter conditions
Wilson wrote in Monday's "Weekly Warm-up" report that the tightening effect is now visible across several assets at once. Along with the 120-basis-point jump in the 10-year Treasury yield since February, the U.S. dollar has strengthened and oil prices have remained elevated. Taken together, he said, those moves amount to a meaningful tightening in financial conditions.
He also noted that global government bond yields have moved above 4% as a whole for the first time since 2000. Wilson said that because the bond market has already priced in higher rates to a large extent, policy pressure on Federal Reserve Chair Kevin Warsh has eased. If this week's CPI report does not surprise to the upside, the upward momentum in long-term yields may start to level off.
The S&P 500's rise has hidden growing divergence
Wilson said the S&P 500 has not fully reflected the tightening in financial conditions because gains have been heavily concentrated in a small number of large-cap technology names tied to artificial intelligence. He said those companies have enough growth to better absorb the effect of rising capital costs.
Under the surface, though, market breadth has weakened. The equal-weighted S&P 500 has lagged the market-cap-weighted index by 6 percentage points since March, a sign that the average stock has faced more pressure from the rise in long-term rates. Wilson said the rapid move higher in yields has already done real damage to most stocks.
Two signals Wilson says investors should watch
Wilson highlighted two indicators that he believes can help determine whether market stress has peaked.
- First is the MOVE index, a gauge of bond-market volatility. Wilson said the level of yields matters less than the speed of the move and the volatility around it. A decline in the MOVE index would be an important sign that pressure in the bond market is easing.
- Second is the relative performance of financial stocks. This week, JPMorgan, Goldman Sachs, Citi and Wells Fargo are all due to report third-quarter results. Wilson said solid earnings from those banks would amount, to a significant degree, to an "all clear" signal for the market.
Recession fears may be priced too aggressively
Wilson acknowledged that persistently higher yields could still become a drag on growth, but said he does not think that has happened yet. He argued that this rise in yields has been driven in large part by economic growth itself and the capital demand that comes with it, rather than by inflation or policy expectations alone.
He also looked at real rates. Using CPI running at about 3.4% year over year and an effective federal funds rate of 3.88%, Wilson said the gap remains well below peak levels seen before previous recessions. In his reading, that suggests the market may be overpricing pessimism on the growth outlook. Combined with his constructive view on the coming earnings season, Wilson said U.S. stocks still have room to improve.
