HomeBusinessAnalysis: Rising Treasury yields pose a test for richly valued US stocks

Analysis: Rising Treasury yields pose a test for richly valued US stocks

By Lewis Krauskopf

NEW YORK (Reuters) – Rising Treasury yields could be the final test of a rally that has made U.S. stocks increasingly expensive and sent them to new record highs.

Expectations that the Federal Reserve will cut interest rates this year helped the S&P 500 gain 10% in the first quarter, even as Treasury yields have accelerated in recent weeks. Valuations also rose, with the benchmark index trading at just over 21 times forward earnings estimates, the highest since January 2022, according to LSEG Datastream.

Now strong economic data is reducing expectations about how much the central bank will cut interest rates this year. Ten-year yields, which move inversely to bond prices, reached 4.4% on Tuesday, the highest level in more than four months.

So far, a resilient economy, robust corporate earnings and excitement about artificial intelligence have helped stocks largely shake off rising interest rates this year. However, some investors are concerned that higher valuations could make stocks more vulnerable if interest rates continue to rise. In addition to raising the cost of capital for companies and households, higher yields can increase the appeal of ‘risk-free’ government bonds compared to equities.

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“The fact that yields here are above a previous ceiling gives pause,” said Chuck Carlson, CEO of Horizon Investment Services. “The trend of these interest rates is troubling because you have a sustained streak of higher highs here that continues today.”

Rising returns have turned the stock market upside down several times in recent years. Stocks sold off in September and October as 10-year yields rose to a 16-year high of just above 5%, only to rise again when yields reversed. In 2022, the S&P 500 plunged 19% as the Fed quickly raised rates to combat rising inflation. On Tuesday, the S&P 500 fell 0.7%, while the 10-year yield was last around 4.35%.

One of the main reasons why investors are more optimistic about rising rates this year is the Fed, which has indicated it wants to cut rates in 2024. But strong economic data has investors doubting whether the central bank will be able to cut interest rates as previously expected.

Futures markets showed on Tuesday that investors had priced in about 70 basis points of cuts this year, compared with more than 150 basis points in January. That is less than the 75 basis points the central bank predicted for this year.

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At the same time, several measures indicate that equity market valuations have become less attractive.

The equity risk premium — which compares the S&P 500’s earnings yield to the yield on 10-year Treasury bonds — turned negative in the first quarter for the first time since 2002, said Keith Lerner, co-chief investment officer at Truist Advisory Services.

“Bonds offer real competition,” said Ed Clissold, chief U.S. market strategist at Ned Davis Research. “So if we were to see 10-year Treasury yields return to 5%, as they did last fall, stocks would likely reflect that and stock valuations should fall.”

Some investors believe a pullback is too late. The S&P 500 has not fallen significantly since October, although pullbacks of 5% or more have historically occurred an average of three times a year, according to data from Bank of America Global Research.

“We have been looking for a 3-5% correction for months,” said Paul Nolte, senior wealth advisor and market strategist at Murphy & Sylvest Wealth Management. “Maybe we’ll finally be on our doorstep.”

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Stocks’ response to rising yields could depend on whether investors continue to believe that the underlying economy remains strong and that inflation continues to cool.

If rates rise “because growth has been much stronger than expected, then investors will be fine with that,” said Damian McIntyre, head of multi-asset solutions at Federated Hermes. “But if growth starts to slow and inflation rises, that will start to weigh on investors’ minds.”

There will be a test with Friday’s US jobs data, with a stronger-than-expected report a possible reason for interest rates to continue rising. Earnings season kicks off later this month, with the S&P 500 expected to post earnings growth of about 10% this year, according to LSEG IBES.

“Stocks can struggle when the gains are there,” says Carlson of Horizon Investment Services. “But if earnings don’t continue to exceed expectations and interest rates now go to their highest level in four months, that will be a problem for the market.”

(Reporting by Lewis Krauskopf; additional reporting by David Randall; Editing by Ira Iosebashvili and Richard Chang)

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