Stock investors are finally getting a taste of a higher interest rate world, and so far, they don't like what they see.
A rapid snap up in Treasury yields has triggered the worst week for stocks since January 2016, and strategists say the sell-off could continue as long as rates make the stock market uncomfortable.
Stocks sold off sharply Friday, capping a volatile week, as rates rose and the dollar strengthened. The Dow fell 665 pointsto 25,520 in its worst day since June, 2016. The S&P 500 shed nearly 2.1 percent to 2,762.
"It's amazing the angst out there," said Bob Doll, chief equity strategist at Nuveen Asset Management. "All along I have said this is going to be a tougher year than last year...you have a sell-off and people are just panicky, like the world's going to end."
The sell-off followed a spike in yields, which temporarily took the 10-year Treasury yield to 2.85 percent Friday. Yields, which move opposite price, jumped after the January jobs report contained the best wage growth since 2009, a warning that inflation could be on its way.
"How long can it last? Tell me where the 10-year yield is going to end up in this noisy period. If it stops going up, stocks will probably stop going down," Doll said. "Moves in interest rates tend not to be smooth. They tend to be abrupt. I don't know where this is going to end. It's been stronger than I thought in the short run."
The new period of choppiness is a major divergence for a market that has not corrected by 3 percent or more since 2016. Soothed by easy central bank policies and fueled by stronger growth, the stock market pushed higher since Trump's election, getting an extra kick into January, after Congress approved tax reform.
"It definitely depends on rates, and the closer we get to [10-year yields at] 3 percent, the greater the likelihood you see a pullback which could be as deep as the 100-day moving average," said Julian Emanuel, chief U.S. equity and derivatives strategist at BTIG. The 100-day moving average was at about 2,632, about a 5.5 percent correction from Friday's levels.
"If we see that and we see the [10-year yield] consistently move toward 3 percent, which we think is a level where people will rethink multiples, that's how this correction becomes material," he said.
The S&P reached its all-time high Jan. 26 at 2,872. "By literally any measure at the top on the 26th we were more overbought than we had been in 30 years," Emanuel said.
Rising bond yields are a reminder that the Fed and other central banks are removing stimulus, at the same time the Treasury is seeking more bond issuance and U.S. deficits are set to rise. Following Friday's jobs report, which contained the best wage growth since 2009, bond pros became more convinced the Fed could move rates faster than the three times it has forecast for this year.
In the bond market, traders were watching the decline in stocks, which itself could cause a reversal at some point, sending investors into bonds as a safety play.
The Treasury this week announced new bigger sizes for Treasury auctions when it announced refunding needs Thursday, and that added to bond-market jitters ahead of next week's auctions.
"I'm calling it the financial game of chicken. Who moves first? If the bond market keeps moving like this, the stock market cannot ignore it," said Nomura fixed-income strategist George Goncalves. "If it keeps nudging rates, ultimately there's going to be a competition between stocks and bonds. Among the things that could stop this sell-off [in bonds] are either an equity market correction or value investors come in and the [Treasury] auctions are good next week."
All through the stock market's post-election rally, interest rates remained mostly contained. That was until the bond market began to challenge whether interest rate assumptions were correct and rates started on a rapid uphill climb in January. The 10-year ended last year at 2.40 percent. The 10-year is the key benchmark rate that impacts a wide range of loans, including home mortgages.
"I think people didn't seem to think — period. They were enjoying the stock market going up, as was I," said Tobias Levkovich, Citigroup chief U.S. equity strategist. "But just because it goes up doesn't mean it's going to keep going up. We've written that [10-year yields] at 3.25 percent would be worrisome, problematic. ...The market is still up year-to-date. The fact you look at it and this [10-year] is less than 3 percent is not a disaster."
But Levkovich's year-end target for the S&P 500 is 2,800, about 33 points above current levels. His forecast is one of the lowest on the street. He said Citigroup's proprietary panic euphoria model, based on investor sentiment, margin levels and other metrics, entered euphoric mode late last year, a contrarian sign.
"It means people are over their skis a little bit. It's got a better than 70 percent probability that the market will be down in the next 12 months," he said. But he added that it doesn't mean the market will be lower, but the vulnerability will be there.
Emanuel said if rates stop moving here, the market could correct in more of a sideways action, and it could stay that way for awhile.
Nuveen's Doll doesn't expect a major correction, but he also sees an S&P 500 level of 2,800 at the end of the year. "For me it's not a whole lot lower but just a lot of frustrating back and forth, up and down until we digest this move up in rates," he said.
There are other factors that could unnerve the market, including the next Feb. 8 deadline for Congress to resolve spending authority issues. Other headlines include the disputed GOP memo on the role of federal agencies in the Russian investigation.
"Investors are in the process of unlearning the lessons of 2017. Political volatility did not translate into stock market volatility in 2017," said Emanuel.
Analysts say the market is in wait-and-see mode while the Treasury market shakes out.
"It's less about the aggregate level of the market [S&P]. It's more about what you should own in the market. Cyclicals over defensive, value over growth, which is kind of not what people want to do historically when bond yields move up. You want to own things like financials, industrials, materials and you don't want to own growth areas, like health care and technology," Levkovich said.
Oppenheimer technical analyst Ari Wald said the sell-off is healthy for the market and it should be relatively shallow. "We're oversold in an uptrend. It's healthy behavior," he said.
Wald said the 50-day moving average at 2,710 is key.
"As you get closer to 2,700 the market becomes tactically attractive. The time for me to get worried is not this pullback. It's how does the subsequent rally look," he said. "On that rally do we see fewer stocks participating? Do we see leadership in countercyclical names? Do we see credit spreads start to widen? Your typical leading indicators of below average performance."