The Bond Market Is Sounding an Alarm -- It Could Mean Big Trouble for the Stock Market

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.

Here are the important details.

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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:

• 1-year Treasury bill pays 3.86%, up 38 basis points.
• 2-year Treasury note pays 4.13%, up 75 basis points.
• 10-year Treasury note pays 4.56%, up 59 basis points.
• 20-year Treasury bond pays 5.06%, up 49 basis points.
• 30-year Treasury bond pays 5.07%, up 43 basis points.

So what? The bond market is sounding an alarm. Investors are selling Treasuries -- which is driving prices lower and yields higher -- because they expect the Fed to raise interest rates to curb inflation. In fact, the 30-year Treasury yield recently hit its highest level in 19 years.

Investors entered the year expecting at least two quarter-point rate cuts, but CME Group's FedWatch tool (which translates the price of fed funds futures contracts into probabilities of different rate outcomes) now shows the Fed's next move as a rate hike by January 2027.

The stock market generally falls when the Federal Reserve pivots to interest rate hikes

Higher interest rates are usually bad news for the stock market. According to U.S. Bancorp:

They raise borrowing costs for companies, which can limit investment, slow expansion plans, and reduce profit growth. They can also weaken demand for interest-sensitive purchases, such as homes and cars and other large items that often require financing.

Since 1999, the Federal Reserve has initiated four rate-hike cycles, and the S&P 500 has always fallen over the next three months. The declines ranged from 1% to 17%, with an average drawdown of 7%.

Here is the bottom line: The yield on Treasury bonds has increased dramatically in recent months as the Iran war has caused inflation to accelerate, indicating that investors expect the Federal Reserve to raise interest rates. Historically, the onset of a new rate-hike cycle has coincided with a decline in the S&P 500.

Trevor Jennewine has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends CME Group and U.S. Bancorp. The Motley Fool has a disclosure policy.