Stocks don’t fall when bond yields rise. It is a problem.

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In the post-Covid world, when bond yields rise, the stock market should fall, but stocks haven’t reacted much to the bond market lately. Something must give.

About last month, the

10 years treasury

The yield has risen to 3.77% from 3.37% on Jan. 18, a yearly low. This was mainly due to stronger than expected economic data, which means that the inflation rate could be falling at a rather slow pace. Sustained inflation means the Federal Reserve, which has been raising interest rates to slow price increases by reducing demand for goods and services, is likely to continue to do so.

In theory, the likelihood that higher interest rates would hurt economic growth should drag stocks lower. That’s been the pattern for the past 18 months or so. The stock market has fallen as yields have risen in response to expectations of higher interest rates, as investors have argued the Fed’s approach meant slamming the brakes on the economy rather than just taking the punch.

The fact that corporate earnings forecasts are falling is evidence that the Fed is having some success.

But the stock market has been stubborn lately. Since January 18, the

S&P500

is up nearly 5% despite bond yields rising over the same period.

Stock valuations follow a similarly odd pattern. Since early 2021, the S&P 500’s aggregate price-to-earnings ratio had declined as the 10-year yield rose, according to Evercore. But for much of this year, the index’s multiple — the amount investors are willing to pay for the profits companies are making — has risen even as yields have skyrocketed.

The upshot, and the problem, is that the yield investors get from owning the S&P 500 has now fallen relative to the yield on the safe-haven 10-year Treasury note.

The point is that the stock market appears to be making some aggressive assumptions that will derail the recent rally if proven wrong. This year’s trading action appears to indicate that investors expect corporate earnings forecasts to rise soon, which would mean stocks would return more at current prices. Expectations that the 10-year yield will soon fall, making equity returns more acceptable relative to government bonds, could also explain the strength of the S&P 500.

Both views of the market point to the same idea: the Fed could soon pause its rate hikes, which could turn earnings prospects more positive and bond yields lower.

That’s all well and good, unless it doesn’t happen because inflation isn’t playing along.

“Either the stock market, at current levels, believes this rate hike will not last, or it is delusional to believe that this is okay while an earnings recession has begun,” wrote Peter Boockvar, Bleakley Advisory’s chief investment officer group. “Now a chicken game between stocks and bonds?”

Things could get ugly again for stocks and bonds.

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com