Market Insider

This is the level of interest rates that could make things really ugly for stocks

Key Points
  • Strategists say the speedy rise in Treasury yields has spooked investors, but a 10-year yield of over 3 percent could be an even bigger problem for the stock market.
  • Treasury yields, which move opposite price, have been rising quickly on inflation expectations, and jumped further Friday on signs of budding wage inflation.
  • The Dow plunged 665 points as investors digested the bond market move which took the 10-year yield to 2.85 percent.
Traders work in the S&P 500 pit at the CME Group's Chicago Board of Trade in Chicago, Illinois, U.S., on Monday, Nov. 28, 2011.
Tim Boyle | Bloomberg | Getty Images

The rapid jump in bond yields is scaring the stock market silly.

But equity strategists say while the speed of the current move in Treasury yields has caught investors flat-footed, a bigger jump in the 10-year yield to over 3 percent could be an even bigger issue.

"I think we're going to get above 3 percent. I think we're going to get to 3.25 percent this year. I think we're going to have to have a 10 to 15 percent correction," said Jim Paulsen, chief investment strategist at Leuthold Group.

Bob Doll, chief equity strategist at Nuveen Asset Management, had expected a slow move to 3 percent by the end of the year, and his target was higher than some. Now, he's concerned the 10-year could reach an even higher level.

"If we get to 3.25 slowly, stocks will be okay. If we get to 3.25 quickly, stocks won't be okay," he said, adding the speed of the current move is slamming equities.

Rising rates can be bad for stocks because at some point higher yielding investments can be more attractive. Higher bond yields also mean higher borrowing costs for corporations.

The bond market has also been struggling with the idea that rising inflation could push the Federal Reserve to raise interest rates more than the three times central bank officials have forecast for this year. That is now infecting stocks, which, until this week, had been rallying even as bonds started to sell off.

"I think it's a problem if we have four rate hikes. It tells you we've got inflation showing up somewhere. I think that would be problematic," he said. Doll said his target for fair value on the S&P 500 is 2,800 for year end. "If we end up at 2,800 this year, it would be a good but not a great stock market for the year. If we get four rate hikes, I think that 10-year is at least 3.25 percent. I think that is a bit much for the stock market to handle."

The Dow fell 665 points, or 2.5 percent to 25,520 Friday, and the S&P 500 fell 2.1 percent to 2,762.

Bond market strategists had expected a more gradual rise in bond yields, which move opposite price. The sell-off in the 10-year took yields from 2.43 percent at the start of January to 2.85 percent Friday.

Stock strategists Friday said the stock market would not stop shaking out until bond yields stop rising.

"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 on the S&P 500 was at about 2,632 Friday.

The bond market's big move in rates gained momentum Friday after January wages rose the most since 2009, sparking expectations that wage inflation is finally picking up. Also this week, the Fed said it now sees inflation reaching its 2 percent target this year.

Some strategists say it's not clear that there's any particular level in the bond market that will stall out the bull market but stocks are clearly stressed.

"It's the pace and it's also the fear of how high inflation might go, and how the Fed might react," said Ed Keon, portfolio manager at QMA. "It's not just the 10-year yield going up. It's the 10-year going up because the market sees inflation going up."