Investors Are Forced To Recalibrate as 10-Year Treasury Yield Flirts with 5%

For the first time since 2007, the yield on the benchmark 10-year U.S. Treasury is flirting with the 5% level, altering calculations for investors who have grown accustomed to equity-friendly interest rates.

The 10-year yield reached 4.997% Thursday before slipping back as low as 4.9% Friday. That still represents a 79-basis-point (bps) increase since Sept. 1, extending a surge from 3.3% a little more than six months ago.

Predictably, stocks fell, as they often conversely suffer from higher bond yields because bonds start to offer more competition to yield-seeking investors. The Standard & Poor’s (S&P) 500 Index fell for the fourth straight day Friday, pushing this week’s losses to 2.4%, during a month when investors’ optimism usually increases as they eye the potential for a year-end holiday rally.

Quincy Krosby, chief global strategist for financial advising firm LPL Financial, posed the question many investors have on their minds: “Simply put, can the equity market continue its climb higher during this traditionally hospitable seasonal period if the 10-year Treasury yield remains—and even climbs above—5%?”

Investors Recalibrate Amid Changing Dynamic

For more than a decade, amid historically low interest rates, investors generally used stocks to boost their returns and bonds to stabilize their portfolios.

After plunging 37% in 2008, the S&P 500 Index only posted annual losses twice in the next 14 years and only failed to produce gains of at least 10% in four of those years. At the same time, relatively steady interest rates meant bond values didn’t change dramatically.

The Federal Reserve, however, began raising interest rates sharply last year. Stock investors, naturally, dislike high rates, as the rising bond yields that accompany them provide more asset-class competition for stocks.

Rising bond yields, of course, also reflect selling in the bond market—and recently in the Treasurys market—in other words, a mismatch in supply and demand for U.S. government securities.

However, the 10-year Treasury note now offers a yield that exceeds consumer inflation by more than 1 percentage point, based on the government’s latest monthly report, marking the first time in years that investors’ “real” rate of return on the 10-year note has turned positive.

Additionally, rising interest rates have made investments in cash-oriented investments much more attractive. Annual yields on money market accounts and certificates of deposit have risen as high as 6.5% with virtually no risk, aside from inflation, of course.

Assessing the Environment for Stocks

The S&P 500 Friday dipped below its 200-day moving average, something Krosby said challenges “the durability of the underlying bull market” that began in early June.

Since then, the index has fallen 1%, reflecting increasing pressure from rising yields. However, Krosby said the current third-quarter earnings report season could hold a key for how stocks perform in the near term, regardless of rising rates.

“Perhaps strong earnings and guidance will counteract the negative effect on the market,” she said. “And perhaps if more investors pull back from assuming that a year-end rally is a done deal, it could allow a contrarian theme to actually underpin a rally.”

What Do Rising Yields Mean for the Bond Market?

Theoretically, rising Treasury yields should lead more investors to U.S. government securities. However, it appears this rise may simply reflect increased issuance of bonds by a government trying to fund its ongoing fiscal budget deficit while finding fewer and fewer willing buyers.

The federal government has issued $15.7 trillion in new securities this year, up 26% from the same period last year. At the same time, the Federal Reserve’s interest-rate hikes have increased its debt-service costs to the highest level since 2009.

Meanwhile, the biggest buyers of Treasurys—Japan and China—increasingly are looking elsewhere. Combined, they still own $2 trillion in U.S. government securities, accounting for 8% of all U.S. debt. But that proportion represents a record low, down by more than two-thirds from the all-time high of 25% in 2007.

With the U.S. government having little choice but to issue new debt to cover its expanding costs, Treasury yields could remain elevated. If so, that would place upward pressure on corporations to keep pace with yields on their bond offerings as they compete to attract capital. In turn, that may depress the value of existing bonds.