Bond prices have drooped amid rising inflation fears, yet stock prices remain robust.

There are growing signs that the Federal Reserve may have to keep interest rates high longer than expected to tame inflation, which is why bond yields are rising and bond prices are falling. High rates are bad news for stocks as well, but equity investors are betting that corporate earnings will strengthen in late 2023 and in 2024.

The 10-year Treasury yield has risen to just over 4% from about 3.7% at the end of June. Despite Fed efforts to cool the economy through a rapid series of interest-rate hikes last year, the labor market remains strong enough that the central bank might have to roll out one or more additional rate hikes.

Bonds, which tumbled sharply last year when the Fed launched its rate-rising campaign, are getting scary again. The MOVE Index, which measures bond market volatility, rose to a level not seen in months. 

The scariest part of all is that the bond market is signaling that it sees more inflation—and the need for rates to remain elevated—from here. Average annual inflation expectations for the next 10 years, as measured by the inflation swaps market, have risen to about 2.27% from around 2.18% in late June. Moreover, the 10-year yield is now about 1.75 percentage points above inflation expectations, up from around 1.53 points at the end of June. The growing difference between bond yields and inflation expectations means that bond traders see a high likelihood that inflation expectations will keep inching higher. 

Rising rates are a negative sign for the economy and corporate profits. Nonetheless, the S&P 500 stock index is up more than 20% from its bear market low hit in early October; the index has even posted a small gain since the end of June when yields started their recent jumps. 

For stocks, there’s now growing risk. Continued destruction to economic demand might drag down earnings, making the stock market even more expensive. The S&P 500’s forward price/earnings ratio is 19 times, which equates to a 5.2% earnings yield. That’s only about 1.2 percentage points above the safe 10-year bond’s yield, which is a lower-than-normal risk premium for equities. In order for stocks to thrive, one of two developments must unfold. Either earnings must grow rapidly or rates must fall. Or both.

“The market seems to be saying it doesn’t care about the near-term earnings recession because the second half 2023 and 2024 are going to be so strong,” wrote Mike Wilson, chief U.S. equity strategist at Morgan Stanley. 

Meanwhile, Sevens Report’s Tom Essay wrote that the stock market is implying that rates are likely to fall from here. 

The market may be right about both earnings and rates over the long term, but the short-term ride is likely to be bumpy.