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Rising interest rates knock stocks, but this isn't the big move that will kill the rally — yet

  • Higher government spending and less central bank easing are two forces that have been driving interest rates higher, and the stock market is finally taking notice as interest rates rise.
  • Stocks are selling off amid a move higher in yields, but strategists do not see the jump in interest rates as a death blow for the record-setting rally.
  • There are three big events for the bond market this week that could send rates even higher through Wednesday. The 10-year hit a high of 2.72 percent, after finishing last week at 2.66 percent.
FED RATE
John Zich | Bloomberg | Getty Images

Stocks may finally be paying attention to the bond market's warnings, but strategists do not see the quick jump higher in interest rates as the move that will kill the equity market's record-setting rally.

While the S&P 500 was celebrating tax cuts and surging more than 7 percent in January, the bond market was selling off. Yields, which move opposite price, rose on expectations government debt is going to balloon and central banks will cut back further on easy money — a powerful combination signalling a lot more government bonds are coming just as interest rates rise.

Treasury yields made a sharp move higher Monday, after a European official called for an end to asset purchases by the European Central Bank. That set off a global surge in interest rates, with government bond yields going higher on both sides of the Atlantic amid worries the European central bankers could now speed up an end to their easing program.

The comment came as the bond market was already speculating that a strengthening economy and the prospect of higher inflation could force the Federal Reserve to raise interest rates at a faster pace than the three quarter-point hikes it has forecast for this year.

The 10-year Treasury note yield, which moves opposite price, jumped to a high of 2.72 percent in early trading, the highest level since April 2014. That yield is very important, since it influences a whole range of business and consumer loans, including home mortgages. It had been at 2.66 percent Friday and at 2.40 percent at the end of December.

"The $64,000 question is when does it matter for stocks? When do historically high valuations start to bump up against rising interest rates? And I don't have an answer. But I think people's eyes are beginning to open ... that this is a big move in interest rates that you have to pay attention to," said Peter Boockvar, chief investment officer at Bleakley Financial Group.

The comments from the president of the Dutch central bank, Klaas Knot, about ending quantitative easing comes just weeks after the ECB cut its bond purchases in half. The moves in Europe were relatively dramatic, with the German 10-year bund yield rising as high as 0.7 percent, and the yield on the German 5-year moved out of negative territory for the first time in two years.

"These are levels we haven't seen in awhile, and it happens in the context of rising inflation expectations and most important central banks with less easing. They were the foot on the neck of interest rates," said Boockvar.

The latest inflation data, the core PCE price deflator for December, showed an annual pace of inflation at 1.5 percent, below the Fed's 2 percent target. But according to 10-year Treasury Inflation Protected Securities, which are used to hedge against higher inflation, the implied inflation rate is at 2.1 percent, the highest since September 2014, said Boockvar.

Some strategists put the fear level for stocks at 3 percent, but they have warned that a rapid move higher, even at a lower level, could make stock investors anxious.

"You're seeing interest rates moving higher, and that has some people worried," said Phil Blancato, CEO of Ladenburg Thalmann Asset Management. "But there isn't specific data telling you inflation is really picking up ... I would say 3 percent on the 10-year would be my first sign of concern."

George Goncalves, head of fixed income strategy at Nomura, said he does not expect this to be the big blowoff for stocks.

"I do think there will be a point in this cycle that there will be a time that stocks are down and bonds are down. I don't think it will be the first time," he said. "If we do get a proper risk off in assets there will be nowhere to run, nowhere to hide, but that's going to be out in the future. Or it may never happen. It may be that stocks roll over and bonds will rally."

Bond strategists also look at possible stock market selling as an escape valve for rising rates, as it would bring buyers seeking safety into the bond market. That would send yields lower, and could ease selling pressure on stocks.

Goncalves said he expects that this current move higher in yields is almost over, but there are three big events through Wednesday afternoon that could significantly impact them and continue to send them higher.

First, the Fed meets starting Tuesday morning, and there's some speculation it could sound a bit more hawkish than it has been in its Wednesday statement, even though no rate hike is expected at what is Fed Chair Janet Yellen's final meeting.

President Donald Trump's State of the Union speech is another major event Tuesday, and he has already promised an infrastructure program. The president is expected to ask Congress for $200 billion, and bond strategists see more spending as a signal there will be even more government debt.

There is also an announcement from the U.S. Treasury on its funding needs for the first quarter. That amount could be $512 billion, according to Wells Fargo estimates. The government could also give some clues on its debt issuance for the year, expected at about $1 trillion, double last year's level.

"The next two to three days are going to give us clarity. It could be the one-two punch that brings us to the near-term high in rates, for at least this week and maybe for the next month," Goncalves said. "If rates get too high, it could short circuit the stock market. That's why I think we're at the point where they're all running out of air — rates, equities, everything ... I feel like we have this crescendo moment if everything lines up like I suspect."

There is also the end of the month on Wednesday, which can influence Treasury trading as big investors rebalance holdings. This month, some speculate that asset reallocation by pension funds could result in the selling of stocks because of their run-up and the purchase of bonds.

Wells Fargo estimated that pensions may need to add $16 billion in exposure to bonds and pare back stock portfolios by as much as $20 billion. Wells strategists noted that as stocks rose to record levels, the broad domestic bond index declined 0.9 percent for the month of January.

Aaron Kohli, fixed income strategist at BMO, said the bond market sell-off does not appear to be driven so much by Fed expectations, since the two-year and other instruments have not seen yields rise as much as 10-year yields. The two-year yield was as high as 2.16 percent Monday but fell back to 2.12 percent.

"You're seeing a lot of shorts coming in. It sows the seeds for the next move lower," he said. "It's a momentum trade."