A Stock Market Indicator Flashes a Warning Last Seen in 2007. Warren Buffett Explains Why It Matters.

The U.S. stock market is on fire despite economic uncertainty related to the conflict in the Middle East. In only two months, the benchmark S&P 500 (SNPINDEX: ^GSPC) has advanced 16%, and the growth-focused Nasdaq Composite (NASDAQINDEX: ^IXIC) has gained 25%.

However, stock prices are closely tied to interest rates, and expectations that the Federal Reserve will raise rates have driven Treasury yields higher. In fact, the 30-year Treasury bond recently recorded its highest payout since July 2007, and stocks fell sharply the last time it happened.

Here are the important details.

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Higher inflation tied to the Iran conflict could force the Fed to raise interest rates

The Iran conflict removed approximately 15% of global oil supply from the market, creating the largest supply disruption in history, according to the International Energy Agency. In turn, gasoline prices have increased sharply, and inflation has accelerated to a multiyear high.

The Personal Consumption Expenditure (PCE) Price Index, the Federal Reserve's preferred inflation gauge, recorded a year-over-year increase of 3.8% in April, the highest reading since May 2023. More alarmingly, core PCE inflation (which excludes food and energy prices) accelerated to 3.3% in April, the highest reading since October 2023. And a forecasting tool from the Federal Reserve Bank of Cleveland shows core PCE inflation reaching 3.4% in the second quarter.

So what? The acceleration in core PCE inflation shows that elevated energy prices are now spreading through the economy, raising production and transportation costs. So, while interest rate cuts were considered a given at the beginning of the year, investors now expect the Fed to hike interest rates by at least a quarter point in 2026 to curb inflation, according to CME Group's FedWatch tool.

Higher interest rates have historically been bad news for the stock market. Since 1999, the Fed has pivoted from cuts to hikes four times, and the S&P 500 and Nasdaq Composite have always declined over the next three months.

Warren Buffett says interest rates are the most important factor in stock valuations

Warren Buffett once explained how interest rates influence stocks. "The most important item over time in valuation is obviously interest rates," he told CNBC in 2017. "If interest rates are destined to be at low levels, it makes any stream of earnings from investments worth more money. The bogey is always what government bonds yield."

Today, government bond yields are climbing because investors expect the Fed to raise interest rates this year. When rates increase, the present value of future earnings declines, putting downward pressure on stock prices. Put differently, high interest rates tend to compress stock market valuations because investors aren't willing to pay as much for future cash flows today.

The 30-year Treasury bond yield recently hit 5.18%, the highest level in almost 20 years. The last time the 30-year Treasury paid that much was July 2007, and the S&P 500 and Nasdaq Composite dropped 20% and 17%, respectively, in the next year. Treasury bonds are seen as risk-free investments because they are backed by the U.S. government. Higher yields force investors to ask: Is it worth buying risky stocks when risk-free bonds offer reasonable returns?

Looking ahead, what actually matters is how high Treasury yields go and how long they stay there. As of May 28, the 30-year Treasury has paid more than 5% for 12 consecutive trading days. That is the longest stint since 2007, when it paid more than 5% for 44 straight trading days. The longer the Iran war keeps oil prices elevated, the longer bond yields will remain elevated, and each day raises the probability of a stock market drawdown.

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