The stock market rally will run out of steam because investors are shifting to risk-off even as inflation expectations ease

  • Longer-term Treasury rates are moving higher, reflecting a risk-off shift among investors, DataTrek said. 
  • The change in long-term Treasurys from mid-January lows suggests downside for stocks.
  • “As long as real yields stay at current levels or increase further, equities may not be able to stage a sustainable rally.”

Upward moves in longer-dated US Treasurys suggest the stock rally of the last seven weeks may not be sustainable, according to DataTrek Research. 

In a Thursday note, DataTrek cofounder Nicholas Colas highlighted that 5-year Treasury yields started the year at 3.99%, and have now jumped to 4.17%.

That reflects a difference of 0.18 percentage points,  which almost mirrors the 0.19 percent point increase in inflation expectations baked into 5-year Treasurys, Colas said. 

But since those yields hit a 2023 low of 3.43% on January 18, they’ve climbed 0.74 percentage points. Meanwhile, inflation expectations have increased by a smaller 0.43 percentage points, from 2.09% to 2.52%.

The same breakdown is reflected in 10-year Treasuries.

The year-to-date change can be chalked up to rising inflation expectations, according to DataTrek, but there’s also another driver behind the upward move in yields. 

“This tell us that real interest rates have been rising over the last month, indicating that investors are demanding a higher inflation-adjusted risk-free rate of return,” Colas wrote. “Put another way, the recent spike in yields is not just about inflation. Rather, it is a sign that investors are growing more risk averse.”

In a recent working paper, Cleveland Fed economists suggested that the central bank won’t be able to bring inflation down to its 2% target without causing a dramatic spike in unemployment and a deep recession. Yet easing that goal, the authors noted, likely wouldn’t impact market expectations that much. 

Colas added that the S&P 500’s peak for the year arrived on February 2nd, shortly after yields bottomed. In the event that investors move toward safer investment options in the market, which yields seem to suggest, then the strength in stocks could wane. 

“As long as real yields stay at current levels or increase further,” Colas noted, “equities may not be able to stage a sustainable rally.”