Reshma Kapadia

Wall Street veterans are picking up on some unusual developments in the economy as bond markets sell off and mortgage rates post their biggest one-week jump in four years.

Louis-Vincent Gave, head of Gavekal, said one odd situation playing out is that the U.S. dollar has weakened against most currencies, despite the rise in food and oil prices alongside yields.

Arthur Budaghyan, head of coreMacro at BCA Research, also touched on this dynamic, noting there had been relatively little volatility in the equity and currency markets despite the surge in bond volatility.

"This divergence is unsustainable and will likely end with greater volatility across most financial markets," he writes in a note to clients.

Budaghyan says U.S. bonds could continue their slide and cool what he sees as an overheating economy. Higher bond yields, he cautions, will jeopardize equity valuations-and market declines will show up before earnings begin to take a hit.

"Without a considerable tightening in U.S. financial conditions-higher bond yields, meaningfully lower share prices, and the negative wealth effect that follows-U. S. growth and core inflation won't drop meaningfully," he says. "If inflation, not real yields, drives the next leg up in Treasury yields, U.S. stocks and the dollar will come under selling pressure."

More strategists are in the camp that inflation isn't going away soon. The shifting geopolitical landscape, with wars in Iran and Ukraine, is reinforcing the push by companies to focus on security and resilience, rather than efficiency, as countries scramble to solidify their access to critical goods.

"That is more expensive in a geopolitically charged world. Inputs are more expensive," says Ellen Zentner, Global Head Thematic & Macro Investing at Morgan Stanley Wealth Management. "It isn't a blip on the radar."

Gave said at a briefing this week he sees growing inflationary pressures as the world rushes to boost depleted commodity inventories, build resilience and invest aggressively to build power infrastructure for AI.

And that inflationary pressure could be supercharged if China-the one big economy contending with deflation rather than inflation-decides to "step on the gas" to revive its sputtering economy, Gave says. Beijing took big steps to stimulate its economy in 2024, such as boosting pensions and providing child care benefits, but dialed back as the war broke out in Iran this year.

Just this week, however, China announced more stimulus. While still incremental, it was the biggest stimulus since 2024. His take: Chinese equities may emerge as the new "anti-fragile" asset class because it's the only major economy that can stimulate its economy meaningfully.

A bond market meltdown and a rise in gas prices is typically a "not happy" combo for the U.S. market, said Gave, who sees the bull market in energy, financials and Japan as "hard to fade."

Others don't see an unhappy scenario for stocks-at least at the moment.

Joyce Chang, chair of Global Research at J.P. Morgan, says the current rates backdrop should not derail equities given the strong earnings anchor at the moment. In a situation where earnings per share growth comes in above 20%, S&P 500 valuations are supported until about 24 times earnings with 10-year yields at about 6%.

But that changes if earnings per share growth decelerates to 10%. At that level, Chang says multiples are only supported up to 18 times earnings.

Chang also notes changes in the structure of the market that could amplify the fallout of a downturn. The current size of the U.S. equity market is about 230% of GDP, double the level it was during the late 1990s tech boom.

"A meaningful and lasting correction in equity markets has bigger consequences, particularly as structurally higher volatility is the new baseline," she says.

Chang is also keeping tabs on U.S. funding gaps. High Treasury yields could more than double U.S. net interest costs from about $1 trillion today to $2.1 trillion by 2035, nearly 5% of GDP. If interest rates settle at 5.3%, up from an average 4.3% over the decade, that adds $3.5 trillion to the debt above projections.

Debt jitters globally are growing. Gave said. French credit spreads are careening amid concerns it could be on the brink of a fiscal, political and financial crisis. The French government is looking at tens of billions of euros in spending cuts to try to calm the bond market, but that discussion is fraught amid sharp divisions between parties ahead of next year's presidential election.

For the U.S., Chang is keeping tabs on August 2027 as a critical period when the U.S. may need to raise the auction size and coupon rate for U.S. Treasury auctions, coinciding with a time when AI capex spending growth will be materially slower-with consensus at 11% versus 83% this year.

Markets are likely to take heed much sooner though. BCA Research's Budaghyan expects investors to view fair-value for stocks to be lower as they begin to factor in higher bond yields and lower long-term earnings per share growth.

Another reason for caution: Bank of America's equity quant team on Thursday said the "Sell Side Indicator" that tracks Wall Street's recommended allocation to equities and that has served as a contrarian signal rose to 57.2% in September, its highest point since March 2022.

The strategists said the indicator is 0.3 percentage points away from flashing a "sell" signal.