Daily Management Review

Growing Treasury Yields Put Highly Valued Us Equities To The Test


Growing Treasury Yields Put Highly Valued Us Equities To The Test
The next recent test of a rally that has driven U.S. stocks to all-time highs and increased their price may come from rising Treasury yields.
Even if Treasury yields have accelerated their rise in recent weeks, the S&P 500 managed to gain 10% in the first quarter due to expectations that the Federal Reserve will lower interest rates this year. Prices also increased: according to LSEG Datastream, the benchmark index is now trading at a premium of just over 21 times forward earnings forecasts, the highest level since January 2022.
Strong economic data is currently undermining predictions about the extent to which the central bank will lower rates this year. Tuesday saw the 10-year yield reach 4.4%, the highest level in more than four months. The yield moves inversely with bond prices.
Upward momentum in the economy, strong corporate profits, and enthusiasm around AI have so far prevented stocks from being much affected by rising yields this year. On the other hand, other investors are concerned that high valuations may make stocks more susceptible if interest rates continue to rise. In addition to increasing the cost of capital for individuals and businesses, greater yields have the potential to make "risk-free" Treasury bonds more alluring than stocks.
"The fact that (yields) are breaking above a previous ceiling here is giving pause," said Chuck Carlson, chief executive officer at Horizon Investment Services. "The trend of these rates is disconcerting because you have this continued series of higher highs here that is being perpetuated today."
Increasing yields have played a major role in the current upheaval of the stock market. When the 10-year yield jumped to a 16-year high of slightly over 5% in September and October, stocks dropped down, but they quickly recovered when rates reversed. The S&P 500 fell 19% in 2022 as a result of the Fed's sharp rate increases intended to curb skyrocketing inflation. The S&P 500 dropped 0.7% on Tuesday, and the 10-year yield was last at 4.35 percent.
Tuesday saw a decline in the major indexes of Wall Street, with Tesla's stock being one of the major drags on the Nasdaq and S&P 500.
Since the Fed has said it plans to lower interest rates in 2024, one major factor contributing to investors' increased optimism about higher yields this year is the Fed. However, investors now doubt the central bank will be able to lower rates as much as initially anticipated in light of positive economic statistics.
Investors were pricing in about 70 basis points of cuts this year, according to futures markets on Tuesday, down from more than 150 bps in January. That is fewer than the central bank's forecast of 75 basis points for this year.
Simultaneously, a number of indicators indicate that stock market prices have lost appeal.
According to Keith Lerner, co-chief investment officer at Truist Advisory Services, the equity risk premium, which measures the difference between the yield on the S&P 500 earnings and the yield on the 10-year Treasury, went negative in the first quarter for the first time since 2002.
"Bonds offer some real competition," said Ed Clissold, chief U.S. market strategist at Ned Davis Research. "So if we were to see the 10-year Treasury yield spike back towards 5% like it did last fall, stocks would probably reflect that and equity valuations would need to come down."
For some investors, a retraction is long overdue. The S&P 500 has not declined dramatically since October, according to data from Bank of America Global Research, although historically, declines of 5% or more happen three times a year on average.
"We have been looking for a 3-5% correction for months," said Paul Nolte, senior wealth advisor and market strategist for Murphy & Sylvest Wealth Management. "We may finally be at the doorstep."
The way that stocks respond to rising rates may vary depending on how confident investors are about the strength of the underlying economy and the rate of inflation.
According to Damian McIntyre, head of multi-asset solutions at Federated Hermes, investors will be fine if yields are rising "because growth has been a lot stronger than expected." "But if growth starts to slow and inflation is climbing then that will start to weigh on investors' minds."
The U.S. jobs report on Friday will be a test; a better-than-expected report could be the cause of the ongoing increase in yields. The S&P 500 is predicted by LSEG IBES to show earnings growth of roughly 10% this year when earnings season kicks off later this month.
"Stocks can weather a lot if the earnings are there," said Carlson of Horizon Investment Services. "But if earnings don't continue to beat expectations and you've got rates now going to four-month highs, that is going to be a problem for the market."