Bond Yields Are Getting Closer to the Next Big Pain Threshold

Updated on
  • Rise to 3% from 2.5% translates into 10% hit on P/Es: Amundi
  • Yield of 3% can take the S&P 500 below 2,500: SocGen
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Bond yields are inching ever closer to the point at which strategists and fund managers say equities will really hurt.

According to strategists at firms including Amundi and Societe Generale SA, the U.S. 10-year Treasury yield climbing up into the 3 percent to 3.5 percent range would reach the “pain threshold” for equities, turning them less attractive than fixed-income assets. The yield surged on Wednesday, spurring fresh declines in equity markets, after data showed January consumer prices rose more than forecast in the U.S. SocGen says a level of 3 percent could send the S&P 500 Index below 2,500, which implies a 6.1 percent slide from Tuesday’s close.

Stock markets around the world tumbled in the past two weeks, with the initial selloff prompted by bond moves after data showed signs of wage growth in the U.S. Since September’s low of 2 percent, the Treasury yield has jumped to a four-year high of nearly 2.9 percent this week. The equity recovery this week has been shaky as investors remain wary of buying the dip.

Many market participants see a further yield rise above 3 percent as a potential game changer, putting pressure on equity valuations while also making it more expensive for companies to borrow money. Here are some views from strategists and fund managers on the theme that has gripped markets this month.

Raphael Sobotka, global head of Amundi’s flexible, risk premia & retirement solutions, by phone:

  • U.S. stock valuations have fallen back but “the market isn’t cheap yet,” and given that rates will continue to rise, the pressure on equity valuation ratios can continue to increase from here.
  • So far, it’s mostly the speed at which bond yields have risen that has spooked investors; a 3 percent yield on U.S. 10-year Treasuries is “a level to watch”
  • The rise from 2.5 percent to 3 percent would translate into a 10 percent hit on price-to-earnings ratios; “It’s fine if U.S. earnings growth continues to be double-digit, but below that, the pressure would be mounting.”
  • Also at 3 percent, bond yields will become attractive again relative to stocks; not likely to spark a big rotation into bonds, but will mean investors will have an alternative to equities to generate returns.

Roland Kaloyan, Societe Generale equity strategist, by phone

  • Equity investors have had an “amazing time” over the past four to five years, but now the rally in bond yields is reaching the pain threshold for a number of reasons, including the pressure on valuation levels; fixed income becomes relatively attractive again when compared with equity dividend yields.
  • The recent improvement in the earnings growth outlook has helped equities absorb bond yields, but with the equity risk premium approaching “levels last seen during the dotcom era,0” any further rise in the 10-year yield to 3 percent would put pressure on the equity market to adjust lower.
  • SocGen’s analysis suggests that a U.S. 10-year yield of 3 percent can take the S&P 500 below 2,500.

Emmanuel Cau, JPMorgan equity strategist, in emailed comments

  • The reason for the move in bond yields matters more for equities than its magnitude; so far, JPMorgan sees the rebound in yields as being fairly consistent with the pick-up in nominal growth expectations.
  • The gap between equity dividend yields and bond yields remains “significant” in all the key regions; bond yields would need to go up about 70bp for the yield gap to move back to its long-term average in the U.S. and by 200bp in euro zone; “we are not there yet.”

Ritu Vohora, investment director at M&G Investments, by phone

  • From an equity risk point of view, the risk premium in the U.S. is about 5 percent, it means that investors are still being paid, even in the U.S. market, to take equity risk today.
  • It would need to get to a level where bond yields are rising because inflation has picked up and central banks are tightening; while current market situation is “unnerving” and rising yields can have an impact on equities, Vohora says the level hasn’t been reached at this point.
  • “Rising bond yields are not reflecting worrying economic conditions.”

Sylvain Goyon, Natixis head of equity strategy, in emailed comments

  • The impact on U.S. earnings is not significant at this point, it’s also getting more complicated to price it in given the changes in the way financing costs will be taxed with the new U.S. reform; bottom line is: we’re far from reaching a point where bond yields start to eat away corporate profits.
  • Inflation not out of control -- it may rise in the U.S. while inflation expectations are toppish in the euro zone. The disconnect should lead to a de-correlation between U.S. and European markets, Goyon said, which supports Natixis’ overweight stance on euro-zone equities.
  • In terms of sectors, the market’s “growing aversion for leverage” is almost inevitable in a context of rising rates; careful on utilities, telecom.

Mark Haefele, global chief investment officer at UBS Wealth Management, in Feb. 12 note

  • No specific level of yields will cause problems for equities; Haefele said he would be more concerned if stocks start to look less attractively valued than bonds, if rising real yields start to boost borrowing costs enough to cut into profits or consumer spending, or if the market starts to fear Fed is behind the curve; “none of these conditions are currently in place.”
  • Global equity risk premium at 4.8% is “well above” the average since 1990, real rates have been steady, Fed remains committed to gradualism; Haefele does not believe yields will rise to levels that will prevent equities moving higher in the next six months.

Credit Suisse strategists including Andrew Garthwaite and Marina Pronina, in Feb. 12 note

  • The problem for equities is when wage growth rises to a range of 3.2 percent to 3.5 percent, as at that stage the labor share of GDP rises, hitting profits and forcing the Fed to turn to a “tight” policy
  • Historically, de-ratings have occurred when inflation rises above 3 percent; Credit Suisse strategists say equities can withstand U.S. 10-year yields rising to 3.5 percent based on their valuation models; 1 percent on bond yields if accompanied by a rise in wages takes about 10 percent off profits

Matthew Luzzetti, senior economist at Deutsche Bank, in Jan. 29 note

  • There is “considerable further scope” for bond yields to rise before they weigh on growth and equities; currently, the neutral 10-year yield in nominal terms is nearly 3.5 percent – its highest level since 3Q 2016 – suggesting that bond yields could rise about 80 basis points from current levels before Luzzetti would begin to worry about them slowing growth momentum.
  • It’s also a threshold where higher yields begin to weigh on equity prices; in the current context, the relationship implies that 10-year Treasury yields would have to rise about 80 basis points from current levels to induce a switch in the bond yield-equity correlation from positive to negative.

— With assistance by Alexandre Boksenbaum-Granier, Aleksandra Gjorgievska, and Beth Mellor

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