Rising Treasury Yields Pose Challenge for Stock Market

by Warren Seah

Treasury yields are on the rise once again, with the yield on the 10-year reaching above 4.3%. This marks its highest point since late 2007, signaling potential trouble for the stock market. The recent rally in August has already fizzled, and higher interest rates on low-risk bonds are reducing the premium investors can expect from riskier assets like stocks. This makes purchasing shares much less attractive, especially considering the high valuation of the S&P 500 and ongoing market volatility.

Unfortunately for stocks, there seems to be no imminent halt to the upward march of yields. Hawkish sentiments from the Federal Open Market Committee meeting last month clash with Wall Street’s expectation that interest-rate hikes for this cycle have come to an end.

Benjamin Jeffery, BMO Capital Markets’ vice president of rates strategy, highlights the significance of monitoring the 10-year yields and identifies a key benchmark: “the true support level to monitor today is 4.335% – the cycle high-yield mark from October of last year.”

While there are various reasons why Treasury yields could rise, they do not always negatively impact stocks. Despite not being seen since the Great Financial Crisis, it is important to note that the past decade and a half have been characterized by abnormally low interest rates. In fact, historic data reveals that payouts on the 10-year T-note have been higher than current levels in the period preceding the crisis.

However, Dennis DeBusschere, President and Chief Market Strategist at 22V Research, points out that rising yields are concerning due to their underlying causes: “the story is not that weakening economic growth and increasing Treasury supply are driving long-term yields higher.”

As the stock market navigates these challenges, investors will need to remain vigilant and adapt accordingly. The impact of rising Treasury yields on stock prices warrants careful observation and consideration.

Economy and Inflation Concerns: A Potential Risk for Financial Conditions

Given the resilience of the economy and wages, it appears unlikely that inflation will decrease significantly. However, this creates an increased risk that financial conditions may need to be tightened further. Consequently, there may be a need for higher interest rate hikes, which could pose challenges for risk-on asset classes and possibly lead to higher yields. Paradoxically, for a broad risk-on rally to occur, economic growth may need to slow down to some extent.

Real Rates Indicate Higher Yields

Nicholas Colas, the co-founder of DataTrek Research, also supports the idea that yields will increase based on real rates – the rates that exclude inflation’s impact.

Unlike in the past October, when 10-year T-notes reached their peak in the previous cycle, inflation expectations are now stable at around 2.3%. Additionally, if we look back at the period before the financial crisis, we can observe that real rates traded between 2% and 2.7%. Currently, with real rates approaching 2% (calculated by subtracting the consumer price index from the fed-funds rate), Colas suggests that we might experience a return to that range.

Therefore, Colas predicts that 10-year yields might ultimately reach approximately 4.5%. He believes that this gradual long-term rate shock still has a way to go and anticipates that equity markets will struggle as it unfolds. Overall, these expectations align with our belief that the following weeks could be challenging.

Be prepared for a potentially turbulent end to the summer.

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