Rising U.S. bond yields are unnerving investors and worsening stocks turbulence as markets confront a pileup of unwelcome news, from last week’s downgrade of the U.S. credit rating to revived worries over regional banks.
Surging yields contributed to last year’s plunge in equities, when the Federal Reserve hiked interest rates to fight soaring inflation. This year, it’s largely been a different story, with bond yields rising on better-than-expected economic data. The S&P 500 has rallied over 16% from its March lows, despite a roughly 50 basis point increase in the yield on the benchmark 10-year Treasury note over that time.
That dynamic has changed in recent days, however, as Treasury yields have approached last year’s high while the S&P 500 has fallen 2% from its July peak. One worry is that higher yields on Treasuries, seen as basically risk-free because they are backed by the U.S. government, will make stocks less attractive at a time when equity valuations have ballooned.
Data from BofA Global Research showed one-month correlations between the S&P 500 and the 10-year yield stood at their most negative since 2000, meaning the two assets were once again moving sharply in opposite directions. The bank’s analysts called rising yields “an underpriced risk” for the equity market. The S&P 500 fell 2.3% last week, its biggest weekly drop since March.
“The market has looked at the rising yields as consistent with a better economy and what the market perceives as lower recession risk,” said Keith Lerner, co-chief investment officer at Truist Advisory Services. However, “If yields continue to move higher, it’s going to be more challenging to get further valuation expansion.”
A series of developments has weighed on the ebullient market mood that had persisted over the last few months. Moody’s cut the credit ratings of several small to mid-sized U.S. banks on Monday and said it may downgrade some of the biggest lenders in the United States. That news followed a downgrade from Fitch of the U.S. credit rating last week.
Meanwhile, weak trade data from China undercut hopes for a swift recovery in the world’s second-largest economy, while Apple shares sold off on Friday following disappointing earnings from the world’s most valuable company.
The Cboe Volatility Index, which measures investor demand for protection against market swings, shot to its highest level in over two months on Tuesday after falling near an over three-year low late last month.
While markets may have grown complacent heading into August, recent developments “have kind of slapped people in the face a little and brought the notion that there is risk in markets back to the forefront of people’s minds,” said Peter Tuz, president of Chase Investment Counsel in Charlottesville, Virginia.
Rising equity valuations have been a concern for investors studying the relationship between bonds and stocks.
As stocks have rallied this year, valuations have become more expensive. The price-to-earnings ratio for the S&P 500 has increased from less than 17 times forward 12-month earnings estimates at the end of 2022, to 19.6 times as of Monday, according to Refinitiv Datastream. The index’s long-term average is 15.6.
Meanwhile, the equity risk premium (ERP), which compares the attractiveness of stocks over risk-free government bonds, has been shrinking for most of 2023 and is around its lowest levels in well over a decade.
According to Lerner, of Truist, the current ERP level has historically translated to just a 1.3% average 12-month excess return of the S&P 500 over the 10-year Treasury note.
The markets will have an important test with Thursday’s release of the consumer price index inflation data for July. A hotter-than-expected reading stands to raise expectations for more hawkish Fed policy and drive bond yields up further.
Even as the economy has staved off a downturn so far, some investors feel rising interest rates could hurt growth in coming months by crimping consumer spending or pressuring corporate earnings.
The market is trying to gauge at what levels will yields or rates start to have negative consequences for stocks, “whether that is a valuation re-rating or economic damage or earnings drag,” said Matthew Miskin, co-chief investment strategist at John Hancock Investment Management.
So far, however, stocks have been “amazingly resilient” to the rise in yields, he added.
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