The Stock Market's Rally Depends on the Answer to This 'Real Question' About Bond Yields

This past week saw a recovery for stock-market bulls, but lingering concerns about the sharp rise in long-term Treasury yields remain. These concerns are compounded by uncertainty surrounding Donald Trump’s return to the White House on Monday and what his policies might bring.

‍

The current rise in Treasury yields is unusual because it coincides with the Federal Reserve cutting its policy interest rate. This divergence is especially significant given that stock valuations are already high, with the S&P 500’s price-to-earnings ratio recently at a historically elevated 21.5. Rising yields make equities less attractive when compared to bonds offering increasingly competitive returns. As analysts at TS Lombard noted in a Friday commentary, “Rising rates would make it difficult for already high valuations to go even higher.”

‍

Treasury yields appeared to dominate market sentiment over the past week. The 10-year Treasury note yield, after hitting a 14-month high above 4.8% on Tuesday, fell sharply following a lower-than-expected December core consumer price index (CPI) reading on Wednesday, ending the week at 4.61%.

‍

Stocks responded positively, with the S&P 500 and Dow Jones Industrial Average both recording their largest weekly gains since early November, coinciding with the presidential election week. This bounce came after the S&P 500 briefly erased all the gains made following Trump’s November 5 election victory, which saw a 6.6% rise culminating in an intraday record on December 6.

‍

The Yield Question: Temporary Relief or Lasting Shift?

The critical question for the market now is whether last week’s decline in yields marked a temporary peak or just a pause in their upward trajectory. Jeff deGraaf, chairman and head of technical research at Renaissance Macro Research, noted that the market’s sensitivity to yields remains significant.

‍

“The real question for the remainder of the quarter, and probably much of 2025, is whether or not the recent overbought proves an interim peak in yields that provides temporary relief for stocks, or if it proves more durable and lasting with yields tumbling back toward 4.0%,” deGraaf said. RenMac’s analysis indicates that the recent drop in yields aligns with a historical zone of average S&P 500 returns over the next 65 trading days, or approximately 13 weeks.

‍

Investors are closely watching how both the level and the pace of change in Treasury yields affect equities. Historically, gradual increases in yields have been manageable for stocks, according to Goldman Sachs analysts. However, rapid rises—such as a two-standard-deviation move, currently around 60 basis points (0.6 percentage points) in a month—can create significant market turbulence.

‍

As of January 14, when yields hit their recent peak, the 10-year yield had risen about 40 basis points over the preceding 30 days and 50 basis points from its early December low.

‍

What’s Driving Yields?

Several factors are influencing the rise in yields. Last week’s December CPI reading and dovish remarks from Federal Reserve Governor Christopher Waller, who hinted at the potential for multiple rate cuts in 2025, provided some relief. However, yields remain elevated despite the Fed’s rate cuts in 2024. Analysts attribute this to concerns about the U.S. fiscal deficit and skepticism over whether Trump’s administration will curb spending. The potential for inflationary pressures from aggressive import tariffs also weighs on the market.

‍

Some analysts suggest that the rise in yields reflects doubts about the Fed’s decision to cut interest rates by 100 basis points in 2024. It may also signal underlying economic strength, which could support stocks in the long term, even as rising yields create short-term uncertainty.

‍

Investors are bracing for market volatility as Trump takes office. Reports indicate he may issue up to 100 executive orders, which could significantly impact global trade and immigration policy. With U.S. markets closed Monday for Martin Luther King Jr. Day, traders will likely spend the shortened week monitoring headlines for policy details.

‍

Ian Lyngen and Vail Hartman, rates strategists at BMO Capital Markets, emphasized that the Treasury market appears to be in a consolidation phase, providing some breathing room. “For the time being, the Treasury market remains decidedly in consolidation mode, and we struggle to envision a breakout in either direction,” they wrote. The recent 20-basis-point decline in 10-year yields puts U.S. rates in a stable position to respond to upcoming Trump-related developments without causing technical disruptions.

‍

While the stock market showed resilience last week, the path ahead remains uncertain. Much hinges on whether Treasury yields stabilize or continue their upward climb, as well as on the direction of Trump’s economic policies. Investors are preparing for a volatile start to the year, with yields and equities likely to remain intertwined in a complex dance.

‍