US equities and Treasury bonds are on a collision course. With inflation persistently high and the Federal Reserve's policy options constrained, the simultaneous rise in stock prices and bond yields cannot last. The widening gap between the two will likely close through a significant correction in one of the markets.
In a recent report, Arthur Budaghyan, Chief Strategist at BCA Research, noted that the current US stock market rally is heavily concentrated in the technology sector, indicating a deterioration in market internals. He warned that the continued upward trajectory of bond yields could trigger a substantial pullback in equities.
Budaghyan argues that only a notable decline in US stocks can push bond yields lower, thereby unleashing disinflationary forces in the economy. The report also cautions that global equities—particularly in emerging markets—are likely to face significant volatility in the coming months.
This outlook suggests that the risk-reward ratio for global risk assets has deteriorated sharply. US stocks, emerging market equities, and high-yield credit are all under pressure, while the US dollar may remain strong in the short term but is still on a weakening trend over the medium to long term.
The Federal Reserve finds itself in a dilemma, with bond market pressures unlikely to ease. The central bank faces a tough decision on whether to raise interest rates, and neither option appears favorable for markets.
According to BCA Research, the yield on the two-year US Treasury note has recently risen above the federal funds rate. Historical data from the past 30 years shows that whenever the two-year yield has crossed above the fed funds rate, the Fed has followed with rate hikes, indicating that market expectations for tightening have increased significantly.
Meanwhile, inflation data continues to exceed target ranges. US core CPI remains well above 2%, while the PPI for final demand (excluding food and energy) has surged to 5.25%, with its six-month annualized change reaching 6.6% in April. The report also highlights that the crisis in the Strait of Hormuz is unlikely to be resolved soon, posing upside risks to oil prices. Given the strong correlation between oil prices and US Treasury yields this year, this further limits the potential for a significant decline in bond yields.
The report emphasizes that even if the new Fed Chair, Kevin Warsh, convinces the FOMC to hold off on rate hikes, the central bank's policy stance and tone are likely to turn notably hawkish. More critically, when inflation rises and the central bank delays action, markets often anticipate the need for more aggressive rate hikes in the future, potentially leading to further selling in the bond market. "A central bank falling behind the inflation curve is negative for both stocks and bonds," the report states.
Despite the S&P 500 hitting new highs, underlying market internals are flashing warning signs. The report points out that the S&P 500 advance-decline line has diverged downward as the index reached new peaks. Currently, only about 55% of S&P 500 constituents are trading above their 200-day moving averages, while the implied correlation among S&P 500 stocks has fallen to historically low levels. BCA Research suggests that extreme divergence in correlations often precedes a collective correction: "We expect correlations to rise, and when they do, most stocks will decline together."
Structurally, the current rally has been heavily reliant on the technology, media, and telecommunications (TMT) sector. Excluding TMT, the broader US stock market remains well below its February highs. Yields on US high-yield (non-energy) corporate bonds are rising, and their credit spreads relative to investment-grade bonds are widening—a typical early warning sign of increasing equity market risk.
The report also highlights that US household stock holdings have reached a record 250% of disposable income. High stock prices are stimulating consumer spending and AI-related capital expenditures, while hyperscalers' investments in data centers are unlikely to slow unless stock prices fall or the cost of capital rises. This implies that only a stock market correction can genuinely unleash disinflationary forces in the economy.
Emerging market equities are in a more precarious position than their US counterparts. The report shows that the rally in emerging market stocks is even more concentrated than in the US. Excluding a few large Asian semiconductor producers (hardware tech), emerging market equities overall remain significantly below their previous highs.
At the same time, local currency bond yields in major emerging markets (as defined by the MSCI Emerging Markets Index excluding China, South Korea, and India) have rebounded, which is a negative signal for their equity markets. During the recent six-week rally in global risk assets, major emerging market currencies failed to appreciate against the US dollar.
The impact of energy and food price shocks is far more severe for major emerging market economies than for developed markets. The report concludes that the earnings outlook for non-TMT sectors in both emerging and developed markets is concerning. Rising oil and food prices, combined with increasing global bond yields, are likely to suppress aggregate demand across a wide range of sectors beyond technology hardware.
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