For the first time in a long time, there’s a conversation on Wall Street about when equities might start to feel the heat from reflation signals in the bond market.
Powered by a rally in oil and bets on further U.S. stimulus, market-derived inflation expectations are near the highest since 2013.
For now, traders bidding up stocks at records are in a sweet spot with the pandemic recovery projected to boost corporate earnings.
But the seven-day sell-off in benchmark nominal bonds—which paused Monday—is reminding investors that faster economic growth brings the risk of higher borrowing costs.
Strategists from Jefferies Group LLC to Goldman Sachs Group Inc. are already turning their attention to the next chapter in the fraught relationship between bonds and risk assets.
“As the market prices in these developments, ‘long-duration’ growth and expensive high-profitability stocks will likely be pressured,” said Jim Solloway, chief market strategist at the investment management unit at SEI Investments Co.
A disappointing jobs report released Friday was taken as yet another sign President Joe Biden will prevail in pushing through his stimulus package. Treasury Secretary Janet Yellen added fuel to the reflationary fire on Sunday, stating that the U.S. can return to full employment in 2022 with enough fiscal support. All that sent bond yields higher across the globe Monday trading, before moves reversed in New York trading.
UBS Group AG analysts see the pain threshold for stocks as a 10-year Treasury yield of 2%. That’s a long way from the current level of around 1.5%, especially while an accommodative Federal Reserve is seen capping rates.
Yet there are straightforward reasons to worry that higher rates will undercut equity allocations. Right now, more than 60% of S&P 500 constituents have a dividend yield above the 10-year Treasury yield. But if the latter climbs to 1.75% by year-end as they expect, that percentage will fall to just 44%, Bank of America Corp. strategists warn.
Another way to consider the relative appeal of equities is the gap between the S&P 500’s earnings yield and 10-year Treasury rates. While that has narrowed to the least since 2018, at 2 percentage points it’s still well above the long-term average.
Faster earnings growth, which in turn supports improving shareholder payouts, could outweigh the drag from higher yields. Among firms that have reported fourth-quarter earnings, 81% have beat estimates, according to Jefferies.