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Portfolio > Economy & Markets > Stocks

The Danger of Rising Bond Yields, and the Opportunities

By Bernice Napach

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Rising bond yields can be good for stocks when the economy is surging but in the current market, where stocks have rallied for more than nine years to record levels and the economy is starting to slow, that’s not the case. But at what level do rising bond yields turn bad for equities now?

Bank of America Merrill Lynch strategists say there’s no magic number, but if they had to pick one, it’s 5% for the 10-year Treasury yield.

That’s the level at which Wall Street’s average allocations to stocks peaks and interest in stocks wanes, according to Merrill’s sell-side indicator.

A 5% 10-year Treasury yield also indicates that stocks are trading at fair value to bonds, based on Merrill’s equity risk premium framework, and that risk-free Treasuries are favored over risky stocks, based on a risk/return basis. The S&P 500 is expected to return 5% annually over the next 10 years, according to Merrill’s valuation framework.

Lindsey Bell, investment strategist at CFRA, says a 4% yield is the level at which the 10-year Treasury becomes competitive with stocks. “The performance of stocks drop off sharply when the 10-year yield exceeds the dividend yield of the S&P by 200 to 300 basis points,” explains Bell. Given that the current dividend yield of the S&P 500 is 1.9%, stocks become less competitive to Treasuries when 10-year yield approaches 4%, according to Bell.

The 10-year Treasury note was yielding 3.24% in midafternoon trading on Wednesday, just below the seven-year high reached Monday, when the 10-year Treasury yield hit 3.25%, buoyed by Friday’s unemployment report showing the jobless rate at its lowest level in 49 years. By day’s end the 10-year Treasury yield had retreated to 3.19%, below the 3.21% close on Tuesday, but the major U.S. stock market indexes were off more than 3% from the previous close.

Traders cited rising Treasury yields, escalating U.S. trade war with China and a recent IMF warning on global growth, including U.S. growth, for the decline, which was led by large-cap tech stocks like Apple and Google.

“Markets are repricing risks,” says David Kotok, chief investment officer at Cumberland Advisors. “Bottom line, rates have to go higher to really zonk markets, but markets are now starting to realize that there is an upward trend in interest rates, that there there is some rising, accelerating inflation, and that the Fed is being placed between a rock and a hard place by Trump because they have to contend with the growing effects of the Trump-Navarro trade war.” Peter Navarro is one of the top trade advisors in the administration.

Kotok notes that investors can now collect 5% yield on federally guaranteed mortgage-backed securities, 4%-plus yield on very high grade tax-free bonds, and 2% on cash equivalents. And with expectations that yields may go even higher, based in part on the Fed signaling more rate hikes this year and next, some bond buyers are stepping to the sidelines while other bondholders and stockholders “don’t need a lot of encouragement to sell on the heels of huge bull markets in both for many years.”

Michael Wilson, equity strategist at Morgan Stanley, doesn’t offer a yield level at which bonds represent a better value than stocks, but in a recent note he wrote that that U.S. equities, especially growth stocks, are now overvalued because of rising real rates and expectations for slowing growth — a sentiment echoed in Wednesday’s selloff. Wilson is not suggesting that investors reduce their stock market exposure necessarily but rather swap from growth stocks into value — a recommendation he adopted in July.

“With S&P 500 upside capped on a valuation basis, it’s more likely that Value outperforms by going down less or simply not going down,” Wilson writes. “The decade long run of Growth versus Value may finally be at risk of turning on a more sustainable basis.”

Bernice Napach

@Think_Napach

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