Market Euphoria May Turn to Despair If 10-Year Yield Jumps to 3%

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It’s getting harder and harder to quarantine the selloff in Treasuries from equities and corporate bonds.

The benchmark 10-year U.S. yield cracked 2.7 percent on Monday, rising to a point many forecasters weren’t expecting until the final months of 2018. For over a year, range-bound Treasuries helped keep financial markets in a Goldilocks state, with interest rates slowly rising due to favorable forces like stronger global growth and the Federal Reserve spearheading a gradual move away from crisis-era monetary policy.

Yet the start of 2018 caught many investors off guard, with the 10-year yield on pace for its steepest monthly increase since November 2016. Suddenly, they’re confronted with thinking about what yield level could end the good times seen since the presidential election. For many, 3 percent is the breaking point at which corporate financing costs would get too expensive, the equity market would lose its luster and growth momentum would fade.

“We are at a turning point in the psyche of markets,” said Marty Mitchell, a former head government bond trader at Stifel Nicolaus & Co. and now an independent strategist. “A lot of people point to 3 percent on the 10-year as the critical level for stocks,” he said, noting that higher rates signal traders are realizing that quantitative easing policies really are on the way out.

U.S. stocks have set record after record, buoyed by strong corporate earnings, President Donald Trump’s tax cuts and easy U.S. financial conditions. The S&P 500 Index has returned 7 percent this year, once reinvested dividends are taken into account, and the U.S. equity benchmark is already more than 1 percent higher than the level at which a Wall Street strategists’ survey last month predicted it would end 2018.

What often goes unsaid in explaining the equity-market exuberance is that Treasury yields refused to break higher last year. Instead, they remained in the tightest range in a half-century, allowing companies to borrow cheaply and forcing investors to seek out riskier assets to meet return objectives.

In fact, investors had largely been better off owning stocks for fixed income than short-term Treasuries. Not so anymore: two-year Treasuries yield 2.12 percent, compared with the 1.76 percent dividend yield on the S&P 500.

“Around 2.9 or 3 percent on the 10-year is where we begin to run into trouble,” said Peter Tchir, head of macro strategy at Academy Securities Inc. “All of this is about the speed of the adjustment. If we are at 3 percent by the end of this week, I don’t see stocks surviving that very well. And rising yields already make it harder for some dividend stocks to do so well.”

Of course, few expect a move of that magnitude, with bond bulls waiting in the wings for the Treasury-market selloff to lose steam.

High Yield, High Risk

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