As U.S. stocks reach new peaks, the rising Treasury yields pose a significant test, especially with the market's increasing valuations. The anticipation of interest rate cuts by the Federal Reserve fueled a 10% increase in the S&P 500 during the first quarter, despite a recent acceleration in Treasury yields. Currently, the S&P 500's valuation stands at over 21 times forward earnings estimates, marking its highest since January 2022, as per LSEG Datastream.
However, robust economic indicators are reducing the expected extent of rate cuts by the central bank this year. The 10-year yield, inversely related to bond prices, recently reached 4.4%, its highest in over four months. Despite the rise in yields, the stock market has remained resilient, supported by a strong economy, impressive corporate earnings, and the excitement surrounding artificial intelligence. Yet, some investors are concerned that high valuations may leave stocks more exposed if interest rates continue to climb, as higher yields make Treasury bonds more appealing compared to equities.
"The breaking of yields above a previous threshold is causing concern," noted Chuck Carlson, CEO at Horizon Investment Services. "The trend of increasing rates, marked by consecutive new highs, is unsettling."
In recent years, surges in yields have disrupted the stock market on several occasions. For instance, a jump in the 10-year yield to a 16-year high led to a market sell-off, only for stocks to rebound when yields decreased. In 2022, the S&P 500 dropped by 19% as the Federal Reserve aggressively hiked rates to combat inflation. Recently, the S&P 500 experienced a 0.7% decline while the 10-year yield hovered around 4.35%.
Investors had been less worried about rising yields this year, partly because the Federal Reserve signaled potential rate cuts in 2024. Nonetheless, strong economic data has led to doubts about the central bank's ability to reduce rates as much as initially expected, with futures markets indicating around 70 basis points in cuts this year, less than the 75 basis points projected.
Moreover, various metrics suggest that stock market valuations are becoming less appealing. For the first time since 2002, the equity risk premium, which compares the S&P 500 earnings yield to the 10-year Treasury yield, turned negative in the first quarter, according to Keith Lerner from Truist Advisory Services. "Bonds are now presenting real competition," stated Ed Clissold, chief U.S. market strategist at Ned Davis Research.
Many believe a market correction is overdue, with the S&P 500 not having seen a significant drop since October. "We've been anticipating a 3-5% correction for months," said Paul Nolte, a market strategist. The market's response to rising yields may hinge on continued confidence in the economy's strength and cooling inflation.
The upcoming U.S. jobs report and the start of the earnings season could further influence market dynamics. "If earnings continue to exceed expectations, stocks can endure quite a bit. However, if earnings falter amidst rising rates, the market could face challenges," Carlson added.
