The US stock market is under pressure as US bond yields rise, which may lead to a decrease in stock valuations. It is expected that the US stock market may face headwinds in the near future. The 10-year US bond yield has risen above the key level of 4.35-4.40%, which may determine whether interest rates will rise to the highs of 2023 again. The market expects the Federal Reserve to cut interest rates once or twice this year, but some also believe that it may restart rate hikes. Investors should closely monitor the relationship between US bond yields and the stock market
Over the past year, investors' consensus on the US economy has undergone several changes: from a hard landing in the first quarter of 2023, to a soft landing in the second quarter, back to a hard landing in the third quarter, a soft landing in the fourth quarter, and now to a no-landing scenario. The market has reacted sensitively to these shifts in sentiment, with the performance of "re-inflation" trades doing quite well in the past few months, outperforming the overall US stock market.
However, as inflation continues to rebound, the correlation between US stocks and the 10-year US Treasury yield has once again turned negative over the past month. Mike Wilson, Chief US Equity Strategist at Morgan Stanley, believes that this suggests that rising US Treasury yields may put pressure on US stocks.
In his latest article, Wilson stated:
We have also been emphasizing that the 10-year US Treasury yield at 4.35-4.40% is a key level for US stock valuations, and this level was decisively broken upwards last week.
As expected, small-cap stocks and other lower-quality/high-leverage cyclical stocks have significantly underperformed the broader market, with their highest negative correlation with the 10-year yield.
US Treasury Yields Breaking Key Levels, Putting Pressure on US Stocks
Since April, the 10-year US Treasury yield has risen by more than 30 basis points, reaching 4.553% at the time of writing.
Wilson emphasizes that since the rebound in US stocks since October last year was largely a result of declining yields leading to an increase in valuation multiples, if yields continue to rise, US stocks may face headwinds in the near future.
The 4.5% level is seen as a watershed for interest rates, which may determine whether rates will rise back to the highs of 2023. Traders previously expected the Fed to cut rates three times this year, but with March CPI data significantly exceeding expectations, the market is currently leaning towards only one to two rate cuts.
Some even believe that the Fed may be forced to restart rate hikes.
Padhraic Garvey, Head of Research for the Americas at ING Bank, stated that the current trend in the 10-year US Treasury yield does not align with historical high-rate periods in the US. If this situation persists, there is a risk that yields could rise to 5%.
Jamie Dimon, CEO of JPMorgan Chase, also warned the market that due to excessive government spending, inflation and rates in the US may remain higher than expected, preparing for the Fed to potentially raise rates to as high as 8%
High-quality Stocks Vs. Cyclical Stocks
It is worth noting that although cyclical stocks outperform the market, high-quality stocks remain the main driving force behind the rise in the US stock market. Wilson believes that it is still advisable to continue holding high-quality stocks.
The recent rise in energy stocks reflects the market's expectation of high inflation and sustained economic recovery. Among various industries benefiting from the "re-inflation" theme (i.e., the second rise in inflation), the valuation of the energy sector remains relatively low. Therefore, allocating to energy stocks may be a cost-effective way to capitalize on the "re-inflation" theme.
Wilson points out that considering the current stage of the economic cycle, it is reasonable for high-quality stocks and cyclical stocks to coexist. If it were in the early stages, the performance of low-quality cyclical stocks and small-cap stocks would be more sustainable.
Finally, Wilson also mentioned that the significant economic growth in the United States over the past year was largely the result of fiscal stimulus, which was achieved through continuously expanding deficits. Investors should pay attention to the economy's dependence on fiscal stimulus for growth and the associated risks.
In April 2020, after the COVID-19 pandemic led to economic lockdowns and the government implemented large-scale stimulus measures, we first noticed this shift in policy dynamics.
At that time, given the significant excess capacity in the economy and the potential positive impact on corporate earnings, we held a very favorable view on this.
Today, our optimism about this dynamic has decreased, as aggressive fiscal spending may ultimately prevent the Federal Reserve from lowering interest rates to a level favorable for small businesses with lower balance sheet quality and less flexible cost structures