Reality May Be Setting in for the Stock Market

Stocks and yields have been rising together recently, a notable development as higher yields in theory should dent demand for riskier assets like stocks. Analysts say U.S. equities have been resilient in the face of rising yields because investors have been focused on strong corporate earnings growth.

But as U.S. yields continue to climb–with the yield on the 10-Year Treasury note recently at 2.71%–reality may be setting in for stock investors. After closing at new records on Friday, the S&P 500 and Dow Jones Industrial Average both fell 0.7% on Monday. The S&P lost another 0.8% in recent trading Tuesday, while the Dow shed 0.9%.

As we noted in our Morning MoneyBeat newsletter Tuesday, analysts aren’t yet calling for an end to the stock rally that has already made January one of the best months ever for major U.S. indexes. But they are beginning to debate how much further yields can rise before they begin to drag down stocks.

Credit Suisse analysts are forecasting that U.S. stocks will begin to face pressure when the 10-year yield reaches 3.5%. Schroders, meanwhile, says stock valuations are “sustainable” as long as yields stay below 3%.

U.S. rates are being bolstered by strong economic growth, the Federal Reserve’s plans for shrinking its balance sheet and raising its benchmark lending rate, and expectations that the U.S. Treasury will ramp up bond issuance this year to fund the rising budget deficit.

Stifel analysts are already forecasting a 5% selloff in the S&P 500 in the coming months as they see the 10-year yield topping 3% during the first quarter. Capital Economics is eyeing the second half of the year for a stock-market slowdown.

By then, “we think that significantly higher interest rates may begin to weigh on the US economy,” the Capital Economics team wrote in a research note. “As growth in the U.S. economy starts to slow, we think that the long-running rally in the US stock market will go into reverse.”