The post-election surge in the stock market, fueled by President-elect Donald Trump’s victory and robust economic indicators, has temporarily overshadowed concerns surrounding rising Treasury yields. While the S&P 500 index, which experienced a 2.3% dip last week, closing at 5,870.62, currently sits above its pre-election level of 5,712.69 (as of Monday, November 4th), a potential shift in the Federal Reserve’s monetary policy could significantly alter this trajectory.
Last Thursday’s apparent pivot by Fed Chair Jerome Powell regarding interest rate reductions has injected uncertainty into the market. Powell’s statement, following a 25 basis point rate cut on November 7th, indicating that the economy shows no urgent need for further rate reductions, has raised concerns about a potential “tighter monetary environment.” This shift in stance carries significant implications for equity markets.
Lowering interest rates typically boosts liquidity, thereby stimulating investment in equities. Conversely, maintaining higher interest rates reduces liquidity, leading to rising yields and potential economic contraction. With US inflation and economic growth showing no signs of cooling, the Federal Reserve’s decision on whether to cut rates further at its December 17-18 meeting will be a crucial determinant of market direction.
This uncertainty is reflected in the rise of Treasury yields. The two-year Treasury yield reached 4.31%, while the ten-year yield climbed to 4.45% on Friday. Irene Tunkel, BCA Research’s chief US equity strategist, warned Reuters that a continued upward trend in yields, without a ceiling, could create problems by leading to a tighter monetary environment. A tighter monetary environment, characterized by higher central bank interest rates, lower bond prices, and higher yields, makes borrowing more expensive, gradually reducing liquidity, hindering growth, and increasing recessionary fears. This is a particularly complex balancing act for the Federal Open Market Committee (FOMC), responsible for determining interest rates and managing economic growth.
The potential for a tighter monetary environment is also a major concern for equity investors, as fixed-income and debt instruments become increasingly attractive compared to equities. Yardeni Research, in a recent analysis, noted that while Powell previously suggested the Federal Funds Rate (FFR) was too restrictive and needed lowering, their internal model suggests the current FFR is already at a neutral rate, based on unemployment and inflation data. Their outlook projects the two-year and ten-year Treasury yields to remain within a range of 4.25% to 4.75% for the remainder of the year and possibly into next year.
Despite this less optimistic outlook, Yardeni Research anticipates a potential “Santa Claus rally” in the S&P 500, pushing it towards 6,100 points by year’s end. This prediction suggests a belief that the market will overcome the potential negative impact of a pause in rate cuts. Similar to the S&P 500, the Nasdaq Composite and NYSE Composite also experienced declines last week but remain above their pre-election levels, indicating a degree of resilience in the broader market. The SPDR S&P 500 ETF (SPY), which tracks the S&P 500, mirrors this overall trend in 2024. The coming months will be crucial in determining whether the market can sustain its current levels or experience a correction in light of the Fed’s policy decisions.
