Stock investors cringe when they see this type of rate jump

People walk by the New York Stock Exchange (NYSE) on December 19, 2017 in New York City.

Rising bond yields do not necessarily mean stocks have to fumble.

The breakout in the 10-year Treasury yield early Friday to above 2.63 percent — levels last seen in 2014 — is signaling that rates could keep rising, and at some point make bond market yields more appealing to investors than stocks. But strategists say that’s not happening yet, and several say that won’t happen until the yield starts to either rise very rapidly, or get somewhere over 3 percent, which is the year-end target of some bond pros.

But strategists also point to the difficulty predicting how the decoupling of bonds and stocks will work after years of central bank easing that has been good for both stock prices and bond prices. Bond prices move inversely to yields.

Now that global growth has improved, and other central banks beside the Federal Reserve appear to be pulling away from easing programs, U.S. yields are moving higher. The benchmark 10-year yield is closely watched across financial markets, and it also influences mortgages and other U.S. consumer and business loans.

“I would think that once it begins to materially crimp housing and potentially weigh on growth that it would begin to matter. I could see that potentially occur if we’re around 3 percent, but as long as the economy continues to do well, and if wages are moving higher that would likely limit the extent of concern over a relatively modest rate rise from here,” said Mark Cabana, head of U.S. short rate strategy at Bank of America Merrill Lynch.

Jack Ablin, CIO of BMO Private Bank, said he thinks the yield could reach as high as 3.5 percent before stock investors really start getting worried, and that would be because investors are looking forward to the worrying level of 4 percent on the horizon.

“I would say my baseline scenario is it’s going to be interest rates that ultimately cause stocks to roll over. I don’t know when but that’s what I’m watching,” he said. “I’m watching the ECB [European Central Bank] and the BOJ [Bank of Japan] because what they’re doing is key…I still think we have maybe not quite 100 basis points, but something like that.”

Not all sectors react the same during a period of rising rates, and high yielders, like utilities could lag. CNBC, using analytics tool Kensho, studied 10 six-month periods of rising yields in the last decade and found utilities, which are high dividend payers, underperformed.

The best performers were materials, up an average 16 percent; consumer discretionary, up more than 15 percent, then industrials and tech, both up 13 percent, followed by financials, up 12.4 percent, according to Kensho.

Ablin said that makes sense, and he expects materials, industrials and financials to outperform this year. “I suspect that’s what’s going to happen again this year too. The value stocks tend to do better when the tide is rising and all ships are floating. That’s when value does better,” he said.

Strategists point to a number of factors behind the recent run-up in rates, including bigger U.S. deficits and an anticipated surge in new supply from the Treasury this year, to pay for tax cuts and entitlement spending. But David Ader, chief macro strategist at Informa Financial Intelligence, said it may be there’s a lack of buyers.

“I think people are a bit surprised by the magnitude of the move, and they’re waiting it out,” said Ader, who has a year-end target of 2.85 percent. “I’m not in the 3 percent camp at all..The approach to 3 will prove interest. I think that’s going to bring in interest beore we get there.”

Lee Ferridge, North American head of macro strategy for State Street Global Markets, also does not see the 10-year making it to 3 percent any time soon.

“When we get to 2.75 then people will start talking about 3…2.75 would be the level to me where the equity market would start to look at it and say it’s getting a little high,” said Ferridge.

He said he believes the 2.75 percent level could be a top because at that level investors may want to buy yield. “I think when you get up to these levels you have a lot of people looking to lock in these types of return,” he said.

Ferridge said he is watching the S&P 500 yield, at 1.80 percent, against the 10-year, and that spread so far is not an issue for stocks, but if it were to move significantly, it could be.

Ablin said he watches the spread between the S&P 500 earnings yield and the yield on corporate BBB rated debt, the rate at which many companies borrow at. He said at 1.5 percent, it’s not a problem for stocks, but another 1 percentage point would matter.

Strategists agree yields are moving higher, but after a decade of extraordinarily easy central bank policies, it’s difficult to say just how markets will react as the central banks step away. The Federal Reserve forecasts three interest rate hikes this year, and some economists expect four. The 2-year yield has jumped over 2 percent in anticipation of Fed hikes. The Fed has also impacted the long end of the curve by tapering back on its purchases of Treasury securities. It reduced its purchases by $20 billion a month by no longer replacing all of the maturing Treasury and mortgage securities on its balance sheet.

“We can’t look at bonds alone and say bonds are in a bear market and stocks are going to be in a bull market. Central banks are unwinding. We’re dealing with a temporary quirk where the stock market just got itself a tax break,” Ader said.

Source: BMO Private Bank

Peter Boockvar, chief investment strategist at Bleakley Financial Group, said he has no magic number where stocks will begin to feel the pressure of rising rates.

“I think if it gets convincingly above 2.63 people will care, but again it’s just impossible to know,” he said. “I think most importantly risks go up the higher interest rates go, whether rates matter at 2.65, 2.75 or 3, the risk matters, and the risk continues to rise as rates rise. It’s coming in the context of extremely rich valuations, high debt levels, and a euphoric attitude toward stocks. If there’s any ‘Debbie Downer’ out there, it’s always higher interest rates.”

Disclosure: CNBC parent, NBC Universal, holds a minority interest in Kensho.

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