Morgan Stanley Wilson: The bond market has already been "raising interest rates" for the Federal Reserve, and the rebound of U.S. stocks depends on two major signals

Author: Bu Shuqing, Wall Street Journal

The dramatic fluctuations in the bond market are quietly taking on the tightening function of the Federal Reserve, and this rare pattern brings a new interpretive framework for the direction of the stock market.

Morgan Stanley's Chief Equity Strategist Mike Wilson pointed out in the latest weekly report that as the yield on the 10-year U.S. Treasury bond has risen by 120 basis points since February, financial conditions have significantly tightened, and the bond market is effectively replacing the Federal Reserve in completing the interest rate hike, which may allow the Federal Reserve to refrain from further raising the policy interest rate. Wilson believes that if the U.S. Consumer Price Index (CPI) data released this Wednesday is moderate, it will help alleviate pressure on long-term yields and market expectations for the policy interest rate.

In this context, Wilson provided investors with two major forward-looking signals: the relative performance of financial stocks and the MOVE index, which measures bond market volatility. He emphasized that changes in bond market volatility are more indicative than the absolute level of yields, and this week’s third-quarter earnings reports from JPMorgan, Goldman Sachs, Citi, and Wells Fargo will serve as a key observation window.

The Effects of Tightening in the Bond Market Are Already Apparent

In the "Weekly Warm-up" report released on Monday, Wilson pointed out that multiple factors are currently at play, and the effects of monetary tightening are already functioning in the market: the yield on the 10-year U.S. Treasury bond has jumped 120 basis points since February, the U.S. dollar index has strengthened, and oil prices remain high, collectively constituting a substantial tightening of financial conditions.

Global government bond yields have now collectively exceeded 4% for the first time since 2000. Wilson believes that with the bond market having significantly priced in higher rates, the policy pressure faced by Federal Reserve Chairman Kevin Warsh has actually eased. If this week’s CPI data does not exceed expectations, the upward momentum of long-term yields may begin to flatten.

The Rise of the S&P 500 Masks Internal Divergence

Wilson noted that the reason the S&P 500 index has not fully reflected the current tightening of financial conditions is that the index's gains are highly concentrated in a few large-cap technology stocks centered around artificial intelligence—these companies' growth potential is sufficient to withstand the impact of rising capital costs.

This structural divergence has already been significantly reflected in market breadth. The equal-weighted S&P 500 index has lagged behind the market-cap-weighted index by 6 percentage points since March, indicating that ordinary stocks have borne more pressure from rising long-term rates. Wilson emphasized that for most stocks, the rapid rise in yields has caused substantial damage.

Two Signals Determine Whether the Worst Moment Has Passed

Wilson suggests that investors focus on tracking two indicators to determine whether market pressure has peaked.

The first is the MOVE index, which is a measure of bond market volatility. Wilson believes that what truly matters is not the absolute level of yields, but the speed of yield changes and their volatility. A decline in the MOVE index will be an important signal of easing pressure in the bond market.

The second is the relative performance of financial stocks. This week coincides with the concentrated disclosure of third-quarter results from JPMorgan, Goldman Sachs, Citi, and Wells Fargo. Wilson believes that if the earnings reports from these banks are solid, it will significantly signal a "full alarm lifted."

Recession Concerns May Be Overpriced

Although Wilson acknowledges the risk that persistently rising yields could evolve into a growth resistance, he currently believes that this scenario has not yet materialized. He pointed out that this round of rising yields is largely driven by economic growth itself and the capital demand it generates, rather than purely by inflation or policy expectations.

From the perspective of real interest rates, Wilson subtracts the current CPI year-on-year of about 3.4% from the effective federal funds rate of 3.88%, resulting in a spread that is far below the peak levels seen before previous recessions, indicating that the market's pessimistic expectations for growth prospects are overstated. Coupled with optimistic expectations for the upcoming earnings season, Wilson concludes that there is still room for improvement in U.S. stock performance.