Last week’s big move up in yields on 10-year Treasury notes sent stocks reeling.
The Dow Jones Industrial Average DJIA, +0.15% has lost more than 500 points since last Wednesday and the S&P 500 SPX, -0.04% is down more than 60 points, or 2%.
The yield on the 10-year Treasury TMUBMUSD10Y, +0.85% had hovered below 3% for months. Then, in mid-September the yield broke through that magic number, past May’s high of 3.11%, and now sits at around 3.24%, its highest yield in seven-and-a-half years.
As yields rise, bond prices fall, so since September 2017 investors holding bonds or bond funds have suffered losses ranging from 0.5% for short-term Treasury ETFs to 12% for ETFs owning long-dated zero-coupon bonds, according to Ben Carlson of Ritholtz Wealth Management. That’s not a lot in the great scheme of things, but a lot of people still think you can’t lose money in bonds.
How will this affect stocks? We saw its short-term impact last week and earlier in the year, when a spike in yields caused an equities sell-off. Stocks recovered and hit new all-time highs, and that may happen again this time.
But interest rates are the life-blood of the economy and the stock market. Mortgage rates have moved up along with the 10-year, contributing to a slowdown in some hot housing markets. Housing starts also have fallen short of late. Interest rates affect everything from home and auto purchases to companies’ capital investment and hiring plans, so a sustained rise is bound to hurt both the economy and stocks.
I’d argue stock investors have begun to price in such a long-term rise in both short- and longer-term interest rates, and the following two charts prove it.
First, let’s look at 2018 to date. As you can see, the yield on the 10-year Treasury has jumped 32% so far this year, while the S&P 500 has gained about 6%, which means we’re on pace for a sub-10% advance in 2018.
Now, let’s look at 2017, where the yield on the 10-year barely budged, and the S&P 500 shot up 19.4%.
Did other things happen then to made stocks move? Of course. Throughout 2017, Wall Street was licking its chops at the prospect of a fat new tax cut, which President Donald Trump signed into law last December. That goosed GDP growth and also helped spur what may turn out to be three consecutive quarters of 20% earnings growth for S&P 500 companies. So, to some degree, investors anticipated all that and took some profits early this year.
On the plus side, we’re looking at maybe a couple more years of strong economic and solid earnings growth, little prospect of recession, and continued gradual increases in the federal funds rate, as Federal Reserve Chair Jerome Powell indicated last week. That means, all other things being equal, still higher 10-year yields over time.
How high can they go? Here’s one more chart:
If yields break through 3.25% and stay there, the next target is the 3.72% closing yield of February 8, 2011. After that, the next resistance level I see on the charts is above 5%, where 10-year yields hovered for long stretches in 2006 and 2007.
Is that likely? Not really, because nobody’s expecting that much GDP growth or inflation. And yields in the high 3s or low 4s probably won’t kill this bull market, either.
But they would definitely reduce stocks’ potential upside in the years ahead. How do I know? They already have.
Howard R. Gold is a MarketWatch columnist and founder and editor of GoldenEgg Investing , which offers exclusive market commentary and simple, low-cost, low-risk retirement investing plans. Follow him on Twitter @howardrgold .
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