NEW YORK, April 3 (Reuters) - Rising Treasury yields could provide the latest test for a rally that has made U.S. stocks increasingly expensive while taking them to fresh record highs.
Expectations that the Federal Reserve will cut interest rates this year helped the S&P 500 (.SPX), opens new tab notch a 10% gain in the first quarter, even as Treasury yields have accelerated their advance in recent weeks. Valuations rose as well: the benchmark index is trading at just over 21 times forward earnings estimates, its richest since January 2022, according to LSEG Datastream.
Now, strong economic data is whittling away at expectations for how much the central bank will cut rates this year. The 10-year yield, which moves inversely to bond prices, hit 4.4% on Tuesday, its highest level in more than four months.
So far, a resilient economy, robust corporate earnings and excitement over artificial intelligence have helped stocks largely shrug off rising yields this year. Some investors worry, however, that elevated valuations could make equities more vulnerable if rates keep climbing. Besides raising the cost of capital for companies and households, higher yields can increase the appeal of "risk-free" Treasury bonds compared to equities.
"The fact that (yields) are breaking above a previous ceiling here is giving pause," said Chuck Carlson, chief executive officer at Horizon Investment Services. "The trend of these rates is disconcerting because you have this continued series of higher highs here that is being perpetuated today."
Rising yields have helped upend the stock market several times in recent years. Stocks sold off in September and October when the 10-year yield surged to a 16-year high of just above 5%, only to come roaring back when yields reversed. In 2022, the S&P 500 plunged 19% as the Fed rapidly raised rates to head off soaring inflation. On Tuesday, the S&P 500 fell 0.7% while the 10-year yield was last around 4.35%.
One key reason investors have been more sanguine about rising yields this year is the Fed, which has signaled it intends to cut rates in 2024. But strong economic data has made investors doubt the central bank will be able to ease rates as much previously expected.
Futures markets on Tuesday showed investors pricing in around 70 basis points in cuts this year, compared to more than 150 bps in January. That is less than the 75 bps the central bank projected for this year.
At the same time, various measures suggest stock market valuations have become less attractive.
The equity risk premium - which compares the S&P 500 earnings yield against the 10-year Treasury yield - turned negative in the first quarter for the first time since 2002, said Keith Lerner, co-chief investment officer at Truist Advisory Services.
"Bonds offer some real competition," said Ed Clissold, chief U.S. market strategist at Ned Davis Research. "So if we were to see the 10-year Treasury yield spike back towards 5% like it did last fall, stocks would probably reflect that and equity valuations would need to come down."
Some investors believe a pullback is overdue. The S&P 500 has not fallen significantly since October, though retreats of 5% or more historically occur three times a year on average, Bank of America Global Research data showed.
"We have been looking for a 3-5% correction for months," said Paul Nolte, senior wealth advisor and market strategist for Murphy & Sylvest Wealth Management. "We may finally be at the doorstep."
Stocks' reaction to rising yields could depend on whether investors continue to believe the underlying economy remains strong and inflation is continuing to cool.
If yields are rising "because growth has been a lot stronger than expected, then investors will be OK with that," said Damian McIntyre, head of multi-asset solutions at Federated Hermes. "But if growth starts to slow and inflation is climbing then that will start to weigh on investors' minds."
A test comes with Friday's U.S. jobs data, with a stronger-than-expected report a possible reason for yields to keep ascending. Earnings season begins later this month, with the S&P 500 expected to show earnings growth of about 10% this year, according to LSEG IBES.
"Stocks can weather a lot if the earnings are there," said Carlson of Horizon Investment Services. "But if earnings don't continue to beat expectations and you've got rates now going to four-month highs, that is going to be a problem for the market."
Reporting by Lewis Krauskopf; additional reporting by David Randall; Editing by Ira Iosebashvili and Richard Chang
