At some point, rising bond yields could start to sting stock prices, a scenario investors have not had to worry seriously about in the eight years since the financial crisis.
But the quick postelection jump in interest rates has some strategists considering at what level higher yields could make stocks less appealing. Some say about a 3 percent yield on the 10-year Treasury note could be that level, but a very fast move higher might also cause problems.
So far, stocks have been taking rising bond yields in stride. But certainly higher yields could eventually discourage corporations from tapping the debt market, which has provided lots of cheap money over the last several years for companies that wanted to fund dividends, share buybacks or mergers. Those buybacks have helped fuel stock market gains. Stocks have also lured in investors who saw low yielding bonds as less attractive than stocks.
Yields moved higher Wednesday after taking a breather on Tuesday. The 10-year was at 2.27 percent after briefly touching 2.30 percent.
"To me, the yield matters when it comes maybe up against some sort of stagflation scenario. As long as the yield is going up, as long as people think the growth expectations are going up as well" stocks should be fine, said Bill Stone, chief investment strategist at PNC Wealth Management. "Certainly inflation expectations are going up. That should feed into earnings expectations for the longer run."
Donald Trump's promise of a hefty package of infrastructure spending coupled with sweeping tax cuts has created excitement in markets, with yields rising on the idea of a higher growth pace and also higher inflation. The president-elect's plan could also add to the U.S. debt, which would also fuel a higher rate environment.
Stock futures were lower Wednesday. Stocks gained Tuesday, even though the reflation trade lifting industrials and banks also faded. The was up 0.8 percent at 2,180 Tuesday, helped by rising energy shares. The Dow was up for a seventh day, rising 54 to a record 18,923. Since the election, the S&P has gained 1.9 percent.
On Wednesday, there are several economic reports, including PPI at 8:30 a.m. ET, industrial production at 9:15 a.m., and NAHB homebuilders sentiment at 10 a.m. Treasury's international capital flows is released at 4 p.m.
Three Fed speakers are out on Wednesday. Minneapolis Fed President Neel Kashkari speaks at 7:45 a.m. ET in New York, St. Louis Fed President James Bullard speaks at 3:05 p.m. in London and Philadelphia Fed President Patrick Harker speaks at 5:30 p.m. ET.
The stock rally still has room to go, even with rates creep higher, analysts said.
"We're only 16 times 2017 earnings, so I would say there's still room. Stocks haven't valued themselves where rates were," said Stone.
Wells Capital's James Paulsen said some of the so-called reflation trade is overdone.
"The pace of Trump's change is going to be much slower, much less aggressive than people have been discounting in the sectors right now," he said.
But he does not believe rising rates will be a problem for awhile.
Paulsen pointed to the rule of 20, an old market metric. The rule indicates the stock market is fairly valued when the price-to-earnings ratio, now about 18 times on a trailing basis, and the rate of inflation, equal 20. Inflation as measured by the consumer price index was running at an annual rate of 1.5 percent in September, and October's CPI reading is expected Thursday.
"I think the stock market is not far off fair valuation on that basis," Paulsen said, noting core inflation is running above 2 percent. "You're also going to grow earnings. We all know earnings are going to be up a fair amount next year."
Paulsen, chief investment strategist, said he also looks at the 10-year yield compared to the inflation rate, and on that basis, yields are still outside historic norms. The 10-year Treasury is currently about the same 2.2 percent rate as core CPI inflation. "The 10-year historically has traded about 2 percent above core inflation rate," he said.
Another factor supporting stocks as rates rise is the pickup in economic growth. Third-quarter GDP is now tracking at 3.1 percent, though fourth quarter is still expected to be just under 3 percent.
"It's not like the only thing that's happening is rates have gone up. We went from sub 2 percent growth to more than 3 percent growth in the third quarter. … We've definitely had a pickup in economic and earnings momentum, which means we can withstand higher rates," he said. "People look at this as though the stock market has gone way up and rates have gone up. The stock market right now is about where it was three months ago."
While the broader market is not impacted by the move in yields, the idea of an even bigger move is still stirring up action.
"It's already a problem for parts of the stock market. … It's just a question of when it affects everything," said Peter Boockvar, chief market analyst with The Lindsey Group. "You can argue it's already affected the FANG stocks from a valuation standpoint. It's a process more than an event." REITs, utilities and other interest-sensitive stocks have sold off since the election, while financial stocks have risen on the prospects of higher profitability in a higher rate environment. Utilities and other dividend-paying stocks ran up as investors were searching for higher yielding investments and were discouraged by super low bond yields.
The election was seen as critical inflection point for investors, changing the view overnight that interest rates will stay low for a very long time. The Fed is set to raise rates in December, but now it is seen as possible that the Fed will be pushed on to a faster rate-hiking track if the stimulus program does boost the economy.
Paulsen said he also did an analysis of what happened when rates were rising going back to 1950.
"One of the things I found was of all the months when the 10-year yield increased, the stock market has gone up almost 10 percent per annum, as long as the earnings growth rate of the S&P exceeded the 10-year yield the trailing 12 months," he said. "However, if the rate went up when it exceeded the 12-month trailing growth rate of earnings, the S&P only appreciated 0.61 percent."
Earnings grew at about 4 percent in the third quarter. "When we had negative earnings growth, that was a real challenge. Not only did rates not go up, they went down. In the third quarter, we now find out earnings growth is 3 to 5 percent, and up they went," Paulsen said. "Suddenly rates went from 1.70 to 2.25. That still might not bite much."
The postelection rally continued to lift stocks Tuesday, but investors jumped back into some of the sectors that were hit hard during the past week. Utilities, down 5 percent since the election, were up 1.7 percent Tuesday. Tech was up 1.3 percent and telecoms rose 2.1 percent. The financials were up just barely in flat trading after a 13 percent gain in the past six sessions.
"One of the things that's happening of late is that we've had a rare thing where stocks have gone up and yields have gone up together, and that reflects to some extent, increasing confidence," said Paulsen.