By Jules Rimmer

The performance of financials and bond market volatility are the the two best lead indicators for stocks, says Morgan Stanley strategist

Global government bond yields now exceed 4% for the first time since 2000

Higher bond market yields just might be making Federal Reserve Chair Kevin Warsh's job easier. With the U.S. 10-year yield jumping by 120 basis points since February, financial conditions have already tightened sharply, and this could have the effect of slowing down the economy to the point that the Fed may not need to hike its policy rate.

Morgan Stanley's chief equity strategist Mike Wilson recommends that investors ought to watch closely the best indicators of this: the performance of financials XLF and bond market volatility.

MOVE, the index of bond market volatility, matters more than the absolute level of rates, Wilson argues

In fact, Wilson argues in Monday's "Weekly Warm-up" note, with the bond market pricing higher rates already, the dollar index DXY rising and oil prices (BRN00) remaining elevated, tightening is at work. Therefore, according to Wilson, a measured inflation print when the U.S. consumer price index is released this Wednesday could be enough to take the pressure off the long end of the yield curve and the market's policy-rate expectations.

Wilson's report suggests that the reason the S&P 500 SPX isn't necessarily reflecting this tightening of monetary conditions is because the upward thrust in the market is being provided by the largest, AI-centric stocks where the growth is sufficiently strong to ignore the rise in the cost of capital.

This explains why breadth in the S&P's slow grind higher of late has been so narrow. The average stock has absorbed more damage from the jump in long rates. The S&P 500 equal-weight index RSP, for example, has lagged the market cap weighted index by 6 percentage points since March.

What Wilson posits is that it's not really the level of bond yields that matters most, but rather the rate of change in bond yields and their volatility, best measured by the MOVE index.

For signs the worst is over, Wilson advises clients to monitor the relative performance of financials, and this sector is especially in focus this week as third-quarter earnings are slated for Tuesday from JPMorgan (JPM), Goldman Sachs (GS), Citi (C) and Wells Fargo (WFC). A decent showing for these banks would go some way to "blowing the all-clear," predicts Wilson.

The performance of financials - in focus this week with earnings - is the best lead indicator for the market, Wilson says

Wilson does acknowledge that there is a risk that higher yields develop into a headwind for growth but at this stage, this is not the case. There's a strong case that much of the jump in yields is attributable to this growth and the demand for capital it generates, he said.

Moreover, if Wilson subtracts the current CPI rate (roughly 3.4%) from the Fed Funds rate (FF00) (3.88% effective) this spread is well below the peaks that have preceded prior recessions, suggesting growth concerns are overdone. This, combined with expectations for a strong upcoming earnings season, leads to Wilson's view that the tape on stocks has room to improve.

-Jules Rimmer

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