When a key part of the U.S. bond market begins to dismiss fresh Federal Reserve rate hikes or harsh talks about inflation, it’s probably time to buy stocks, according to James Paulsen, Leuthold Group’s chief investment strategist.
To back up his call, Paulsen looked at the relationship between 10-year Treasury yield TMUBMUSD10Y,
and the S&P 500 Index SPX,
in several past Fed tightening cycles. He found five periods since the mid-1980s when the benchmark 10-year yield peaked, suggesting that bond investors were “flashing” before the Fed stopped raising interest rates.
In 1984, when the 10-year yield hit nearly 14% in June (see chart), it was just a few weeks before the S&P 500 index bottomed out. The S&P 500 then rose sharply in August, even before the central bank ended its tightening cycle with interest rates close to 11.5%.
Bond investors blinked in 1984 months before the Fed halted rate hikes and stocks soared higher.
Leuthold Group
A similar pattern emerged in the 1988-1990, 1994-1995, and 2018-2019 tightening cycles, with a 10-year prime yield signaling the definitive end of the Fed’s rate hikes.
“Everyone wants to know when the Fed will stop raising interest rates,” Paulsen wrote in a note to clients Tuesday. “However, as these historical examples show, perhaps the more appropriate question for equity investors is: When will 10-year Treasury yields fall?”
The benchmark 10-year yield matters to financial markets because it drives prices for everything from mortgages to corporate bonds. Higher borrowing costs can slow economic activity and even trigger a recession.
Despite the 10-year increase in 2022 (see below), it has continued to rise in each of the last 11 weeks for the past 11 weeks, hitting 4% earlier this week, or its highest level since 2008, according to Dow Jones Market Data.
The 10-year Treasury rate hasn’t blinked yet
Leuthold Group
“The Fed could soon try to raise interest rates to 4%, 4.5% or even 5%,” Paulsen warned. “Most importantly for investors, the stock market usually bottoms not when the Fed stops raising rates, but when the bond market flashes.”
Stocks closed higher on Tuesday after a string of strong corporate gains, with the Dow Jones Industrial Average DJIA,
up more than 300 points, the S&P 500 rose 1.1% and the Nasdaq Composite Index COMP,
0.9% higher according to FactSet.
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