Stocks Face A Rough Road Ahead On Rising Bond Yields

U.S. stocks are facing a rough road ahead on rising bond yields, which push valuations lower.

The benchmark 10-year Treasury bond yield, which crossed the psychological threshold of 4% recently, continued to climb last week. It now stands at 4.16%, compared to 2.87% a year ago.

Bond yields are a critical variable in almost every equity valuation model. In the Capital Asset Pricing Model (CAPM), for instance, bond yields are the "credit risk-free" asset, determining the opportunity cost of capital invested in equities.

When bond yields rise, the opportunity cost of capital committed to equities rises, and therefore, the expected return on equities decreases. As a result, equities command lower valuations.

That could explain the sell-off in the areas of the equity market where valuations have been rising in recent months, like Nasdaq. The tech-heavy index lost 300 points or more than 2% weekly.

Spikes in bond yields are nothing new on Wall Street. They come and go as the bond market adjusts to the relative scarcity of capital.

A couple of things make the recent spike in bond yields worrisome. First, it hasn't been that magnitude since 2006-7, when the Great Recession and a stock market crash followed it.

Second, it comes after Fitch downgraded the U.S. debt last week, meaning that the U.S. debt is no longer as risk credit risk-free as it used to be. As a result, it raises risks across all financial assets, making it harder for investors to protect their capital from market risks.

Third, the spike in bond yields comes despite good July consumer inflation numbers released during the week.

"The July (consumer) inflation report was reminiscent of the good old days," George Mateyo, chief investment officer at Key Private Bank, told International Business Times. "With both 'headline' and 'core' inflation rising 0.2% month/month, one could surmise that the post-pandemic inflationary impulse has faded. Said another way, in 2019, the average monthly increase in inflation was 0.2%, and that's what we've experienced in the past two months in 2023."

Lower, not higher, bond yields should follow these good inflation numbers.

Something else must be at play. Jason Mountford, trend analyst at Q.ai, an AI-powered investment app, attributes the spike in bond yields to a not-so-good July producer price index (PPI). "It's no secret that the Fed prefers to look at PPI as the measure of inflation, which means they're likely to see the overall inflation picture as glass half empty," he told IBT. "And that means the prospect of more rate rises."

David Russell, vice president of market intelligence at TradeStation, agrees, providing further insight on the rise of long-term interest rates. "The PPI was a reminder that inflation isn't gone yet," he told IBT. "Long-term yields are also rising as investors grapple with the flood of Treasury issuance without the Fed providing QE. This creates a strange situation with rates rising even as inflation cools."

The situation could be better in the corporate bond market. "We're starting to see bond yields move higher on the possibility of higher rates for longer — particularly in the corporate bond market," Mandy Xu, head of derivatives market intelligence at Cboe Global Markets, told IBT. "The Cboe iBoxx Investment Grade Corporate Bond Index futures, for example, is down 1% in the last two trading sessions — a much steeper sell-off than the S&P 500 Index."

Still, Xu doesn't see any significant correction ahead for equities that resemble last March's. "Unlike March, the stress in the banking system has subsided significantly. While risks remain, the fear of contagion is gone," she explained. "We can see this in measures of S&P implied correlation, which spiked in March after the collapse of SVB spurred a broad sell-off across sectors. The CBOE 1-month Implied Correlation Index jumped to a high of 50 as the threat of a bank run stoked fears of recession."

But this time around, she noted that it remains at a 5-year low of just 20%. "Overall level of broad market risk, as measured by the VIX Index, also remains muted at just 16, which is 10 pts below the high we saw in March," Xu added.