Stock Market Investors Get an Urgent Warning From the Bond Market. History Says This Will Happen Next.

The U.S. stock market has been rocketing higher despite economic uncertainty created by the Iran war. Since April, the S&P 500 (SNPINDEX: ^GSPC) and the Nasdaq Composite (NASDAQINDEX: ^IXIC) have advanced 13% and 19%, respectively, amid a wave of strong financial results.

However, investors got an urgent warning from the bond market last month. The 30-year Treasury yield hit a 19-year high, hinting at potential for steep losses in the stock market. Here are the important details.

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Investors expect the Federal Reserve to raise interest rates in 2026

Entering 2026, investors expected the Federal Reserve to cut its benchmark interest rate by half a percentage point throughout the year. But the odds of lower rates in the near future have essentially dropped to zero since the Iran war began. The conflict has disrupted global oil supplies on an unprecedented scale, driving prices to a multiyear high.

High fuel prices have started to filter into core inflation (which excludes volatile spending categories such as food and energy) by raising transportation and manufacturing costs, especially in energy-intensive industries such as chemicals, lumber, and metals. In April, core PCE inflation (the Fed's preferred gauge) hit 3.3%, the highest level since late 2023.

The Fed may overlook transitory increases in headline inflation, but officials are prepared to raise interest rates if core inflation stays elevated. And the market now sees that as the most likely outcome. Rather than rate cuts, traders are betting on one quarter-point rate increase later this year, according to CME Group's FedWatch tool.

The recent spike in Treasury yields hints at a sharp decline in the stock market

The bond market serves as a barometer for the economy. Prices drop, and yields rise, when investors are worried that inflation will force the Fed to raise interest rates. That happens because investors sell bonds, pushing prices down and yields up, until payouts offer satisfactory compensation for the perceived risk.

Treasury bond yields are particularly important because they represent the risk-free rate against which all other investments are measured. Treasuries are backed by the full faith and credit of the U.S. government, which means there is essentially no chance of a default.

Treasury yields spiked last month as investors priced in the probability of at least one rate increase in the next year. In particular, the 30-year Treasury yield stayed above 5% for 11 straight trading sessions (the longest stint in almost two decades) and peaked at 5.18% on May 18, the highest level since July 2007.

What happened last time? The S&P 500 and Nasdaq Composite plummeted 21% and 18%, respectively, over the next year. And the same thing could happen this time because higher yields will force investors to rethink how much they are willing to pay for risky stocks when risk-free bonds offer reasonably attractive returns.

"There is growing risk that rising bond yields, along with a slowing economy or inflation pressures, could trigger a stock market correction," according to Goldman Sachs. But the impact on the U.S. economy could run even deeper. "History suggests that central bank rate increases in response to an energy price shock are classic precursors to recession," according to JPMorgan Chase.

Here's the bottom line: The recent spike in Treasury yields serves as a warning to investors. Higher bond yields could lead to steep losses in the stock market. In addition, the probability of Fed rate increases has increased, and rate increases in response to energy shocks have often pulled the U.S. economy into a recession.

JPMorgan Chase is an advertising partner of Motley Fool Money. Trevor Jennewine has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends CME Group, Goldman Sachs Group, and JPMorgan Chase. The Motley Fool has a disclosure policy.