Equities in the danger zone after rise in interest rates

It had been coming for some time, and now it has actually happened: the U.S. 10-year Treasury yield has risen above the psychologically important 5% threshold.

This is a particularly relevant level for institutional investors. After all, a ‘risk-free’ return of 5% increasingly competes with equities, especially if the perception takes hold that inflation may start to ease again in the foreseeable future.

That is not yet the case, however. U.S. inflation figures remain persistently too high, as data released at the end of last week showed. They are still clearly above the Federal Reserve’s 2% target.

At the same time, the latest Bank of America market survey shows that institutional investors expect U.S. inflation to be lower twelve months from now than it is today. In that environment, allocating more capital to Treasuries becomes increasingly attractive.

No sell signal

A 10-year Treasury yield above 5% is not favourable for equity prices, particularly for sectors such as technology and real estate, as well as for highly leveraged companies. However, average earnings growth is currently at an exceptionally high level.

For the companies included in the S&P 500, earnings are currently expected to rise by around 30% on average this year (source: Bloomberg, FactSet). That is an unusually strong figure and is partly driven by the AI boom. This provides a significant counterbalance to the rise in long-term interest rates.

Risk of a correction

Stock market corrections – defined as a decline of at least 10% – are generally difficult to predict. Investors should, however, always take them into account, as they are an inherent risk of investing.

A survey conducted by Market Pulse last week asked professional investors what level the U.S. 10-year Treasury yield would need to reach in order to trigger a stock market correction. The overview below shows the average view among respondents:

It is clear that the 5.00%–5.75% range is seen as a level that could trigger a market correction. With the current U.S. 10-year Treasury yield now above 5%, equities are therefore entering the danger zone in that respect.

Perhaps more important than the exact level of the 10-year yield is the speed at which it rises. A gradual increase is generally seen as less problematic than a sudden sharp move higher.

Although the U.S. 10-year Treasury yield is now once again at its highest level since 2007 – apart from a brief spike in October 2023 – long-term yields have broadly fluctuated between 3.7% and 5.0% in recent years:

All eyes in the investment world are now focused on the Fed’s interest rate decision. The overwhelming consensus expects a 25-basis-point rate hike. It is clear that the Fed is operating behind the curve. Tomorrow we will find out whether Warsh will indeed raise rates, although the Fed appears to have little choice.

The attempt by Scott Bessent, the U.S. Treasury Secretary, to slow the rise in long-term interest rates by purchasing Treasuries has so far failed completely. And that highlights one of the key challenges facing the United States.

With U.S. government debt having risen to more than $40 trillion, combined with a budget deficit of around 6% (!) in the current fiscal year, the country can ill afford significantly higher interest rates.

A difficult dilemma for investors

The U.S. 10-year Treasury yield having risen above 5% is not supportive of equity valuations. At the same time, expected earnings growth remains well above historical norms. According to the current consensus, that growth rate is expected to roughly halve next year, but even 15% would still be a strong figure.

Much will depend in the coming period on what the Fed does and, more importantly, on inflation. Professional investors expect inflation to be more or less at its peak and to be lower a year from now, but there are of course no guarantees.

The sharp rise in energy prices is adding further upward pressure to inflation. An end to the conflict in the Middle East – and preferably also an end to the war in Ukraine – would be important for future price developments.

Investors concerned about a possible correction may consider reducing some of their existing positions in order to keep some cash available.

Sources: Martin Crum, iex, Market Pulse, Bloomberg, Dan Meyers