Wilson believes that the market's concerns about the risk of recession may be excessive, and there is still room for improvement in the US stock market.

Written by: Bu Shuqing, Wall Street Journal

The extreme volatility in the bond market is quietly taking on the Federal Reserve's tightening function, and this rare pattern has brought a new interpretative framework for the direction of the stock market.

Mike Wilson, Chief Equity Strategist at Morgan Stanley, pointed out in the latest weekly report that as the yield on the US 10-year Treasury bond has risen by 120 basis points since February, financial conditions have significantly tightened. The bond market is effectively replacing the Fed in completing the interest rate hike, which may mean the Fed does not need to raise policy rates further. Wilson believes that if the US Consumer Price Index (CPI) data released this Wednesday is moderate, it will help ease long-term yield pressure and market expectations for policy rates.

In this context, Wilson has provided investors with two major 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 levels of yields, and this week's third-quarter earnings reports from JPMorgan, Goldman Sachs, Citi, and Wells Fargo will serve as a critical observation window.

The Effects of Bond Market Tightening Are Already Apparent

In the "Weekly Warm-up" report released on Monday, Wilson pointed out that a combination of multiple factors is currently at play, and the effects of monetary tightening have already begun to take hold in the market: the yield on the 10-year US Treasury bond has jumped by 120 basis points since February, the US dollar index has strengthened, and oil prices have remained high, all of which constitute significant financial tightening conditions.

Global government bond yields have now collectively exceeded 4% for the first time since 2000. Wilson believes that given the bond market's substantial pricing of higher rates, the policy pressure faced by Federal Reserve Chairman Kevin Warsh has actually eased. If this week’s CPI data does not show higher-than-expected increases, the upward momentum of long-term yields may begin to stabilize.

The S&P 500's Gains Mask Internal Divergence

Wilson pointed out that the S&P 500 index has not fully reflected the current tightening of financial conditions because the index's gains are highly concentrated in a few large-cap, AI-focused tech stocks – these companies' growth potential is sufficient to withstand the impact of rising capital costs.

This structural divergence is already evident in market breadth. The equally weighted S&P 500 index has lagged behind the market capitalization-weighted index by 6 percentage points since March, indicating that regular stocks have borne more pressure from the rise in long-term rates. Wilson emphasized that for most stocks, the rapid rise in yields has caused significant damage.

Two Signals Determine Whether the Worst Moment Has Passed

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

The first is the MOVE index, which is a measure of bond market volatility. Wilson believes that what truly matters is not the absolute level of yields but the speed of yield changes and their volatility. A decline in the MOVE index will be an important signal for easing bond market pressures.

The second is the relative performance of financial stocks. This week coincides with the concentrated disclosure of third-quarter results from JPMorgan, Goldman Sachs, Citi, and Wells Fargo. Wilson believes that if the earnings reports from these banks are solid, it will signal a degree of "full alarm lifted."

Recession Concerns May Be Overpriced

Although Wilson acknowledges that the continuous rise in yields carries the risk of becoming a growth impediment, he currently believes that this scenario has not yet materialized. He pointed out that this round of rising yields largely stems from economic growth itself and the resulting capital demand, rather than solely being driven by inflation or policy expectations.

From the perspective of real interest rates, Wilson notes that by subtracting the current CPI year-on-year rate of about 3.4% from the effective federal funds rate of 3.88%, the resulting spread is far below peak levels before previous recessions, indicating that the market's pessimistic expectations for growth prospects are overestimated. Coupled with optimistic expectations for the upcoming earnings season, Wilson concludes that there is still room for improvement in the US stock market.