Bond Markets Clear Path for Stock Rally by Ignoring a Near-Term Risk

Recent rate moves are supporting another solid stock market rally. (CHARLY TRIBALLEAU / AFP via Getty Images)

Key Points

• A “bull steepening” of the U.S. Treasury yield curve, with the 2-year and 10-year gap at 68 basis points, signals potential stock market gains.
• Goldman Sachs projects 2.1% real GDP growth for next year, slightly above the 2% Wall Street consensus.
• Analysts forecast a 15.5% advance in corporate earnings next year, with the S&P 500 median target at 7,600 points.

Bond markets are doing their part to deliver a Santa Claus rally for stocks as investors up the ante on more Federal Reserve rate cuts in the new year and brush off inflation worries in the world’s biggest economy.

A softer-than-expected inflation reading for the month of November, published last week, along with the expected new leadership at the Fed pushing for deeper rate cuts, have driven short-term Treasury bond yields sharply lower over the past two weeks. That’s likely to support the case for a so-called Santa Claus rally, which typically occurs just after the Christmas holiday and into the first two days of January.

Further pressure has been building on shorter-term Treasury bill yields as the Fed begins its monthslong effort to ease liquidity concerns in the banking sector through a program of regular monthly purchases expected to last until late spring.

Collectively, the moves have triggered a so-called “bull steepening” of the U.S. Treasury yield curve, where short-term yields fall faster than longer-dated ones. In fact, the gap between benchmark two-year Treasury bond yields and 10-year Treasury note yields was last pegged at 68 basis points, the steepest since January 2022.

A bull steepening of the Treasury curve is typically a positive signal for stocks, as it suggests aggressive central bank action to lower interest rates and stimulate economic growth while at the same time keeping longer-term inflation expectations in check.

But it can also be an omen.

“There’s a concern that the yield curve is steepening too fast, and that the increase in the 10-year yield in Japan could continue to push up yields in the long end of the curve in the U.S. and globally,” said Justin Bergner, portfolio manager at Gabelli Funds.

“There’s also an issue of market confidence in the Fed chair’s ability to control inflation and maintain the value of the U.S. dollar, as well as a perception in the markets that Kevin Hassett is not perceived to be an independent Fed chair,” he added.

The Bureau of Economic Analysis is likely to publish data later this week showing third-quarter GDP growth slowed to around 3%, down from the 3.8% pace recorded over the three months ending in June, but still a robust pace of advance despite the disruption of the government shutdown.

Goldman Sachs sees real GDP growth for next year—which backs out the boost from inflation—at around 2.1%, just ahead of Wall Street’s consensus estimate of 2%. The Fed sees GDP growth at 2.3% with Personal Consumption Expenditure index inflation running at around 2.5%.

However, while the bond market remains sanguine over inflation risks, precious metals prices are hitting fresh all-time highs. That contrast suggests investors aren’t entirely on the same page when it comes to the impact of tariffs on consumer price pressures.

Gold has risen more than 68% so far this year, topping the $4,420-an-ounce mark earlier Monday, while silver has soared more than 36% over the past month alone.

Those gains could reflect rising geopolitical tensions, however, as opposed to inflation concerns. Weekend developments in Venezuela, where U.S. officials have seized tankers carrying crude to China, have stoked oil prices, while stalled peace talks between Russia and Ukraine have boosted flows to safe-haven assets.

Analysts at 22V Research, led by Dennis DeBusschere, argue that the Fed isn’t trying to “run the economy hot,” but rather attempting to support growth without stoking inflation.

“The distinction is important,” he said. “The speed limit for growth has shifted higher due to strong productivity growth. It looks like the economy can grow 2.5% without causing an inflation problem.”

Solid GDP growth with stable inflation would provide a solid backdrop for the market’s current forecast for corporate earnings, which analysts see advancing by around 15.5% next year, based on LSEG data.

The median end-2026 price target for the S&P 500, meanwhile, sits at around 7600 points, a 10.5% advance from current levels.

Stocks, in fact, have reacted well to the bond market’s new normal. The S&P 500 is up 2.4% from last week’s trough on Dec. 17, and booked its third consecutive gain on Monday to close just a few points shy of the benchmark’s all-time peak of 6901 points.

“The U.S. is set to remain the world’s growth engine, driven by a resilient economy and an AI-driven supercycle that is fueling record capex and rapid earnings expansion,” said JPMorgan’s equity analysts, led by Ken Goldman and Pedro Martins, in a recent outlook report.

“Despite AI bubble and valuation concerns, we see current elevated multiples correctly anticipating above-trend earnings growth, an AI capex boom, rising shareholder payouts, and easier fiscal and monetary policies,” the pair added.

Write to Martin Baccardax at martin.baccardax@barrons.com