Without a Calmer Dollar and Bond Market, the Stock Market Will Struggle to Rally

Stocks advanced at the start of the holiday-shortened trading week on Monday, but analysts suggest the equity rally may depend on the cooperation of the bond market and the U.S. dollar. Both Treasury yields and the dollar climbed on Monday, extending recent gains that have created headwinds for the stock market. These moves follow the Federal Reserve’s announcement last Wednesday, signaling fewer interest-rate cuts in 2025 than previously expected.

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The 10-year Treasury yield reached its highest level since late May, while the ICE U.S. Dollar Index (DXY) hit a two-year high. Notably, yields move inversely to bond prices. On Monday, the 10-year yield rose by 7.2 basis points to close at 4.594%—its highest finish since May 29, based on 3 p.m. Eastern time levels, according to Dow Jones Market Data. Meanwhile, the DXY increased by 0.4%, climbing to 108.09, after reaching 108.54 last Friday, its loftiest level since November 2022.

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Despite Friday's temporary pullback in yields and the dollar—sparked by a key inflation report offering some relief—both metrics resumed their climb on Monday. These upward movements represent mild headwinds for equities at current levels, according to Tom Essaye, founder of Sevens Report Research. However, Essaye warned that further increases could pose more significant challenges for stocks.

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In Monday’s thin preholiday trading session, equities managed to weather these pressures. The Dow Jones Industrial Average erased earlier losses to close with a gain of nearly 100 points, or about 0.2%. The S&P 500 rose 0.8%, driven by strong performances from semiconductor stocks, while the tech-heavy Nasdaq Composite advanced 1%.

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Despite Monday's gains, major indexes remain in negative territory for December. Last week saw losses across the board, with the Dow and S&P 500 underperforming. However, the S&P 500 is still on track to end 2024 with an impressive annual gain of over 25%. Both the stock and bond markets are scheduled for an early close on Tuesday and will remain shut on Wednesday in observance of Christmas.

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A noteworthy development in the bond market last week was the return of the yield curve to its normal shape. The yield curve, which plots yields across Treasury maturities, had been inverted for an extended period, with short-term yields exceeding long-term ones. This inversion, particularly between the 3-month Treasury bill and the 10-year Treasury note, has historically been a reliable recession indicator. However, its prolonged inversion during a robust U.S. economic environment raised doubts about its predictive power this time.

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While some analysts remain cautious about the implications of the inversion’s end, others view it as a signal of a broader shift in the economic landscape. Lisa Shalett, Chief Investment Officer at Morgan Stanley Wealth Management, argued that the normalization of the 3-month/10-year curve may reflect a transition from the disinflationary growth seen over the past 15 years to a new phase of reflationary nominal growth.

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This shift, she suggested, could put downward pressure on valuations for long-duration stocks, as higher long-term yields reduce the present value of future earnings.

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Higher yields generally act as a drag on equities, making it harder to justify elevated valuations. Essaye emphasized that stability in the bond and currency markets is crucial for stocks to regain their footing. He noted that declines in the 10-year yield and the dollar index would provide the calm environment needed for equities to sustain their rally. Reassuring economic data or Federal Reserve commentary supporting continued rate cuts could also help stabilize these markets.

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“Bottom line, calm currency and bond markets are what stocks need to continue to rally,” Essaye wrote. “The sooner these markets calm—meaning declines in the 10-year yield and the dollar index—the better it will be for markets.”

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In conclusion, while stocks showed resilience on Monday, the broader trajectory of the equity rally depends on external factors such as bond yields and currency movements. Investors are closely monitoring these dynamics, particularly as the year-end approaches, to determine whether stocks can overcome current challenges and maintain their upward momentum.

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