Morgan Stanley's Wilson: The bond market is already “raising rates” for the Fed, two major signals needed for a US stock rebound

The intense volatility in the bond market is quietly taking on the Federal Reserve’s tightening function, a rare situation that brings a new framework for interpreting the stock market’s direction.

Morgan Stanley’s chief equity strategist Mike Wilson noted in the latest weekly report that with the US 10-year Treasury yield rising by a cumulative 120 basis points since February, financial conditions have tightened significantly. The bond market is, in effect, replacing the Federal Reserve in carrying out rate hikes, which may mean the Fed does not need to raise policy rates further. Wilson believes that a moderate US Consumer Price Index (CPI) reading, to be announced this Wednesday, would help alleviate pressure on long-term yields and shift expectations for policy rates.

Against this backdrop, Wilson provides investors with two forward-looking signals: the relative performance of financial stocks and the MOVE index, which measures bond market volatility. He emphasized that changes in bond market volatility are more indicative than the absolute level of yields. This week, the Q3 earnings of JPMorgan, Goldman Sachs, Citi, and Wells Fargo will serve as a key observation window.

Bond Market Tightening Effects Already Evident

In the "Weekly Warm-up" report released Monday, Wilson pointed out that multiple factors are currently overlapping, and the monetary tightening effect is already at work in the market: the 10-year US Treasury yield has jumped 120 basis points since February, the US dollar index has strengthened, and oil prices remain high—together, these constitute a substantial tightening of financial conditions.

Global government bond yields have now generally exceeded 4%, marking the first time since 2000. Wilson believes that with the bond market already pricing in much higher rates, the policy pressure facing Fed Chairman Kevin Warsh is actually alleviated. If this week’s CPI data does not exceed expectations on the upside, the upward momentum of long-term yields may ease.

S&P 500 Gains Mask Internal Divergence

Wilson pointed out that the S&P 500 index failed to fully reflect the tightening financial conditions because its gains are highly concentrated in a few large-cap tech stocks centered around artificial intelligence—these companies’ growth is strong enough to withstand the impact of rising capital costs.

This structural divergence has become obvious in market breadth. Since March, the equal-weighted S&P 500 index has lagged the market-cap-weighted index by 6 percentage points, showing that ordinary stocks have suffered more pressure from rising long-term rates. Wilson emphasized that, for most stocks, the rapid climb in yields has caused substantial damage.

Two Key Signals Will Determine If the Worst Is Over

Wilson suggests that investors closely track two indicators to determine whether market pressure has peaked.

The first is the MOVE index, indicating bond market volatility. Wilson believes that what truly matters is not the absolute level of yields, but rather the speed and volatility of yield changes. A decline in the MOVE index would be an important signal that bond market pressure is easing.

The second is the relative performance of financial stocks. This week, with JPMorgan, Goldman Sachs, Citi, and Wells Fargo releasing their Q3 earnings, Wilson believes that if these banks’ reports are robust, it would largely signal an “all-clear” for the market.

Recession Fears May Be Overpriced

Though Wilson acknowledges the risk that persistently rising yields could become a drag on growth, he currently believes this scenario has not materialized. He points out that this round of rising yields stems largely from economic growth and its resulting capital demand, rather than purely inflation or policy expectations.

From the perspective of real rates, Wilson subtracts the current year-over-year CPI of about 3.4% from the effective federal funds rate of 3.88%, and the resulting spread is far lower than the peak levels preceding previous recessions, indicating the market’s pessimism about growth prospects is overstated. Coupled with optimistic expectations for the upcoming earnings season, Wilson concludes that US stocks still have room to improve.