We might sound like a broken record, but stocks gained again last week as the bull market rolls on. The Dow joined the party, as it climbed back above 50,000 and finally closed at a new high, joining the S&P 500, Nasdaq, and small-cap Russell 2000, which all have already been making new highs the past few weeks.
Crazy Eights
The S&P 500 climbed for the eighth consecutive week, the longest win streak since nine in a row in late 2023. What makes this all the more impressive is that the S&P 500 has gained nearly 18% during the streak, officially the second best eight-week win streak ever, topping the previous record from 1997.
We found only seven other eight-week win streaks that also saw the S&P 500 up more than 12%. Future returns were quite strong, with stocks never lower a year later, up 16.9% on average, and a median of 20.1%. We like to say momentum begets momentum, and this is another feather in the cap for the bulls going forward.
Enter Stage Left, Mr. Warsh
After more than eight years in charge of the Fed, Jerome Powell has officially stepped down as chair and Kevin Warsh takes the baton to lead the largest central bank in the world.
Powell navigated COVID, a generational spike in inflation, an extremely aggressive rate hike cycle in 2022, Washington drama, wars, and more in his eight years. Did he get everything right? No, as he didn’t foresee the jump in inflation in 2022 (who can forget “transitory,” a phrase we seem to be flirting with again), but overall, he has navigated things well and done an admirable job. Other than two months in 2020, the economy avoided a recession and investors have done well under his leadership. In fact, the Dow gained 97.0% during his tenure, for an annualized return of 8.5%, which ranks eighth out of the 16 Fed Chairs. Fun stat: Janet Yellen was the shortest Fed Chair (height, not tenure), but stocks gained a very impressive 12.9% annualized under her leadership, ranking second only to Eugene Black.
Buckle Up?
Historically, markets have often tested new leadership at the Fed. The most famous example is in 1987, when the market crashed soon after Alan Greenspan took over. There were many other times trouble brewed within six months of new leadership as well, with multiple challenges in in the 1910s and 1930s, and in more recent times after Arthur Burns and Paul Volcker took over.
In fact, the Dow historically has had an average peak-to-trough decline of 15.2% within the first six months of new Fed leadership. The good news is the past three new Fed chairs saw relatively calm seas, so this isn’t a sure thing by any means. Of course, with inflation and higher yields, the market very well could test Warsh, but stay tuned for that!
What’s Behind the Bond Market Rout?
Looking at the equity market hitting all-time highs, you could be forgiven for thinking all is well. But you don’t have to look too far to see where there’s pain: the bond market has been struggling. We’ve been talking about an inflationary growth regime since the start of the year, and equities doing well while bonds struggle is par for the course in this environment. Still, it has been a particularly rough stretch for bond investors (and most people are bond investors with at least some of their portfolio).
Treasury yields surged late last week, but this was not a one-day event. Yields have been climbing across the curve since the U.S./Israel-Iran war began and the Strait of Hormuz was closed. From February 27, the eve of the war, through May 18:
- The 2-year Treasury yield rose from 3.37% to 4.12%, an increase of 0.75 percentage points.
- The 10-year Treasury yield rose from 3.94% to 4.56%, an increase of 0.62 percentage points.
These are significant moves, and they’ve come about in a relatively short period of time.
The Front End of the Yield Curve Says the Fed Is Behind
The 2-year yield at 4.12% means that the market expects the short-term policy rate to average that level over the next two years, well above the current policy rate of 3.63%.
In fact, the probability of a rate hike in 2026 has increased to 70%, making a rate hike this year the base case (just barely, as anything between 30% to 70% is really a coin toss). Here’s a chart showing market expectations for policy rates over the next several years.
- On the eve of the crisis, markets were expecting a couple more rate cuts this year, taking the policy rate to almost 3%. Markets did expect a series of rate hikes from 2028 onwards, but gradually, with the policy rate exceeding its current level only in 2031.
- The entire curve has now shifted above the current policy rate of 3.63%, implying markets now expect the Fed to hike rates this year and continue lifting them beyond 2026.
In other words, expect rates to stay higher for longer as the Fed looks to get a grip on inflation. Hence, it shouldn’t be a surprise that even long-term rates are rising. On the other end of the yield curve, the 30-year Treasury yield hit a peak of 5.19%, the highest level in 30 years. It’s pulled back to about 5.06% now, but for reference, it was 4.61% on the eve of the war.
The bond market clearly doesn’t like elevated inflation, which is why yields are rising. But there’s also the prospect of falling demand from abroad.
Why Yields Jumped Last Week
Long-term yields are rising for two broad reasons. First, inflation risks are moving higher. Second, demand for Treasuries looks less reliable at the margin, especially as foreign government bond yields rise. To be clear, the Treasury selloff began well before Friday. Yields have been rising since the war began, which points to the bigger drivers: oil prices, the Strait of Hormuz, and the inflation impulse that follows. But the sharp move late in the week had two immediate catalysts:
- Japan’s central bank signaling that more rate hikes may be coming as inflation surges.
- The Strait of Hormuz remaining shut, with the U.S.-China summit failing to produce additional pressure on Iran to reopen it.
Japan Still Matters
Let’s start with Japan. Japan’s wholesale price inflation, as measured by its Producer Price Index (PPI), surged 2.3% month-over-month in April, the fastest pace in three years. Expectations were for a 0.7% increase. Instead, prices jumped on the back of higher energy and chemical product prices. The year-over-year pace rose to 4.9%, the fastest since May 2023.
That raised the odds of another Bank of Japan (BoJ) rate hike, with markets pricing in a 75% probability of a move by June. One BoJ policymaker even called for raising rates “at the earliest stage possible.” The 2-year Japanese government bond yield hit 1.43%, well above the current policy rate of 0.75%. Translation: Markets think the BoJ is behind the curve. That is a striking shift from 2022, when inflation spiked but the 2-year Japanese yield was still below zero. Meanwhile, the 10-year Japanese government bond yield surged to 2.80%, the highest level since 1997. For perspective, the 10-year yield was below 0.25% in 2022, when yield curve control was still in place.
One crucial difference between what’s happening now and the 2022 inflation episode is that we now have significant fiscal stimulus in the works as well, from the relatively new Japanese government headed by Prime Minister Sanae Takaichi.
So How Does a Move in Japanese Yields Affect U.S. Treasury Yields?
The simplest answer is that higher foreign yields reduce demand for Treasuries at the margin. Japanese investors were starved for yield for years, and that helped support demand for U.S. Treasuries, especially when Japanese and European yields were negative. That world is gone.
This shows up most clearly in the U.S. term premium. The term premium is the extra compensation investors demand for holding a long-term bond instead of rolling a series of short-term bonds. It reflects inflation uncertainty, but also supply and demand. Right now, the U.S. deficit is running near 6% of GDP, which means Treasury supply is large. At the same time, foreign yields are rising, which reduces the relative appeal of U.S. Treasuries.
The term premium is not directly observable—it has to be modeled. But the New York Fed’s model shows the 10-year term premium is now above 0.80%, close to the highest level in more than a decade.
This is a big regime change. After 2014, the term premium collapsed and eventually turned negative between 2016 and 2020. A negative term premium is odd on the surface. Why would investors accept less compensation for owning a long-term bond rather than a series of short-term bonds? There were two big reasons:
- Inflation was low, and inflation volatility was even lower.
- Demand for Treasuries was enormous, including from foreign buyers and from investors using bonds as a portfolio diversifier when the stock-bond correlation was negative.
The term premium rose after 2020 as Treasury supply surged amid fiscal stimulus, but it dipped back below zero in late 2021 and stayed there even during the 2022 inflation spike. It was only in late 2023 that it decisively moved back above zero. It’s moved higher over the past year, and especially recently.
When the term premium rises, it usually reflects one or more of three things:
- Higher inflation volatility
- Excess Treasury supply
- Lower demand for Treasuries
We have all three right now. That is the problem.
Closed Strait = Higher Oil Prices = Inflation Problem
The Strait of Hormuz remains shut, and oil prices remain elevated. Higher oil prices mean higher inflation, and higher inflation means higher yields. It really is that simple.
The problem last week was that the U.S.-China summit produced no progress on the Middle East front. There was hope that China might pressure Iran to reopen the Strait of Hormuz. That did not happen. China said it wants oil flowing again, but it appears comfortable with Iranian control of the strait, including the possibility of Iran charging ships a toll to pass through. That remains unacceptable to the U.S., at least for now.
The Bottom Line
The Middle East stalemate continues, though there seems to be more positive news over the last few days. Once again, turmoil in the bond market rather than the stock market increases odds of a U.S.-Iran deal. Without a deal, and with each passing day, global oil reserves are being drawn down, including in the U.S., which is drawing oil from its Strategic Petroleum Reserve (SPR) at a record pace. The likelihood of the inflation problem growing even larger increases as a result, which is why bond yields are surging.
To put a bow on all this, the main takeaway is that the bond market is absorbing the cost of higher inflation. Equities remain strong because we have inflationary growth (rather than stagflation). Nominal GDP growth is running hot, and that benefits corporate revenues and profits. AI-related capex is another tailwind, though this is also pushing inflation higher and putting even more upward pressure on bond yields. For now, a Fed led by Warsh looks set to look past this immediate bout of inflation and let things run hot. We’ll see how long the bond market allows them to remain comfortable with that stance.
S&P 500 – A capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The NASDAQ 100 Index is a stock index of the 100 largest companies by market capitalization traded on NASDAQ Stock Market. The NASDAQ 100 Index includes publicly traded companies from most sectors in the global economy, the major exception being financial services.
The views stated in this letter are not necessarily the opinion of Cetera Wealth Services LLC and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not take into account the effects of inflation and the fees and expenses associated with investing.
A diversified portfolio does not assure a profit or protect against loss in a declining market.
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