The “most important variable” to watch in the markets right now: Morning Brief

This is the conclusion of this morning’s letter, which you can read Sign in Delivered to your inbox every morning, along with:

The “systemic problem” of the stock market is rearing its ugly head again.

The 10-year Treasury yield (^TNX) has risen nearly 50 basis points over the past month and is above 4.6% for the first time since May 2023.

During this period, the S&P 500 (^GSPC) has fallen more than 1% and all signs of expansion in the stock market have all but disappeared. Mike Wilson, Morgan Stanley’s chief investment officer, wrote in a note to clients on Sunday that the poor performance was a symptom, not the cause, of market unrest.

It starts with the prices that have crossed a limit.

Several strategists view the 4.5% threshold as a key indicator of when the rising 10-year yield could weigh on stocks. Similar rate hikes in April 2024 and fall 2023 coincided with some of the largest declines in the current bull market.

“The correlation between stock returns and bond yields has turned significantly negative (yields rise, stocks fall and vice versa) – something we have not seen since last summer,” Wilson wrote.

Additionally, Wilson emphasizes that better-than-expected economic data is not responsible for pushing yields higher.

“The combination of these factors makes interest rates the most important variable to watch as we enter 2025,” Wilson wrote.

Higher interest rates are seen as a headwind for stocks, particularly in more speculative areas of the market such as small caps, where more companies could be forced to refinance at a higher borrowing rate. This helps reinforce the market’s recent large-cap bias and the status quo of Big Tech’s concentrated market position.

“The recent rise in interest rates is another reason to stay on the quality curve, as companies with stronger balance sheets/lower leverage are likely to remain less interest rate sensitive,” Wilson wrote.

Wilson argues that the extension of the stock market rally that many have been calling for in 2025 could be on hold for now unless interest rates fall and other factors prompt it.

Rising interest rates are usually accompanied by a rise in the dollar. The U.S. dollar recently hit a two-year high and is also heading toward levels that Wilson argues also has the potential to weigh on stocks with greater foreign sales exposure.

As our Chart of the Day showed last week, this could include some companies that have contributed to the S&P 500’s recent earnings growth. S&P 500 companies, with less than half of their revenue generated in the U.S., increased their profits by nearly 14% a year earlier in the third quarter, according to FactSet. That far exceeded the 1.8% profit growth for companies that generate more than half of their revenue in the United States.

The story continues

The key question for investors is finding a way out of the higher interest rate quandary. Michael Kantrowitz, chief investment strategist at Piper Sandler, argues that a series of weaker-than-expected economic data could be the trigger for lower interest rates – and revive hopes of a Fed rate cut in 2025.

“We believe we need to see employment easing in order for interest rates to come down,” Kantrowitz said in a video sent to clients on Jan. 3.

What matters in this narrative is how much weaker economic data would actually be welcome.

Strategists have often argued that stocks would be better off if the Fed cuts less than hoped and interest rates stay elevated because the U.S. economy is outperforming than if the Fed cuts interest rates because economic growth is slowing significantly. It’s a fine line for business: being sick enough to miss school, but not sick enough to warrant a hospital visit.

So far, the labor market has already cooled significantly over the past year, contributing to the market’s tailspin when the unemployment rate hit 4.3% in July. Fed Chairman Jerome Powell has made it clear that his team believes a further weakening in the labor market is “undesirable.”

So are lower interest rates at any price really the answer for stocks with growing upside potential? With the release of the December jobs report on Friday, we’ll take a closer look at whether the market is truly waiting for bad economic news to ease its woes with higher interest rates.

Josh Schafer is a reporter for Yahoo Finance. Follow him on X @_joshschafer.

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