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Bond yields moving from 'sweet spot' to riskier area where they could threaten stock market gains

  • The 10-year yield is getting close to 3 percent, and that is a level that could set off alarm bells for investors.
  • Bank of America Merrill Lynch studied the relationship between higher yields and stocks and found the correlation is inconsistent and stocks have not been really hurt in periods of higher rates.
  • Markets flip-flopped and stocks sold off sharply Wednesday after bond yields rose in response to the Fed's meeting minutes.
  • Now markets are hyper-focused on all Fed speak and will be paying close attention to New York Fed President William Dudley on Thursday morning.

The 10-year Treasury yield is getting dangerously close to 3 percent, a level that some say will set off serious alarm bells for some stock investors.

While the entire Treasury market is moving, the 10-year is the benchmark, the rate most widely watched by investors and the one tied to a whole range of business and consumer loans, including mortgages. On Wednesday, it rose to a fresh four-year high of 2.957 percent, and that helped turn a strong stock market rally after the Fed minutes into a bloodbath. The Dow closed down 166 points at 24,797.

That puts the focus again on the bond market Thursday and the events that could impact trading. That would include an appearance by New York Fed President William Dudley on Thursday morning and a 7-year bond auction Thursday afternoon.

The 3 percent level does not necessarily have to stop the stock market's bull run, but it is a level where the probability for losses in the S&P 500 increases, according to a new report from Bank of America Merrill Lynch.

"You're on the cusp of leaving the sweet spot, but that being said, the rising rates are not necessarily bad for the stock market. Yes, from your finance courses, a higher discount rate means you're going to see lower valuations, all else being equal. But the 'all else being equal' missing ingredient is a high growth rate," said Marc Pouey, equity and quant strategist at BofAML.

Pouey said the "sweet spot" for stocks is a 10-year yield between 2 and 3 percent, but the fact that not only U.S. growth but global economic growth is strong makes it more likely that stocks will be able to positively navigate a zone where the 10-year is above 3 percent.

"There is no magic number. You have periods of positive correlations and periods of negative correlations," Pouey said.

Treasury strategists say the 10-year could make a quick run toward 3 percent and could do that as more information comes out from the Fed. The Fed did not tip its hand, in the January meeting's minutes, as to whether it would raise rates more than the three times forecast. But some Fed watchers viewed the comments in the minutes as being more confident about the path they are on. After its March meeting, the Fed will release new projections for rate hikes and the economy.

"Now the yield trend is intact. The new high is important," said Chris Rupkey, chief financial economist at MUFG Union Bank. "It looks like 3 percent is the next stop. … I think [stocks] can get used to this at some point. They certainly didn't like it today. … I think it's important for stocks to see how many times [the Fed] will go this year. They signaled yes they are going in March. It's still up in the air how many times they will go this year."

There are a number of Fed speakers Thursday. Markets will especially be watching for comments from New York Fed President William Dudley after Wednesday's turbulent trading. Dudley holds a 10 a.m. ET briefing about Puerto Rico and the Virgin Islands, but he could say something beyond that topic.

"Never count Bill out. He's been a big market mover, and if the market is wrong, given his years of experience, he'll try to redirect the markets if we've got it too wrong," Rupkey said.

Atlanta Fed President Raphael Bostic speaks at 12:10 p.m. on the outlook, while Dallas Fed President Rob Kaplan speaks at 3:30 p.m. in Vancouver on trade.

As for rising rates, Pouey studied 15 periods of rising 10-year yields since 1954 and found stocks generated positive returns 90 percent of the time. "I think what's interesting in this bull market is the best year for stocks was 2013, when you saw the 'taper tantrum,' 100 basis points higher in yield," he said. The S&P was up more than 29 percent that year.

BofAML said over the past 64 years, the correlation has ranged from negative 63 percent to positive 75 percent. The relationship tended to be negative in some of the 1960s through the 1990s, with rising yields being negative for stocks. The average level of rates then was 7.5 percent.

But in this century, the correlation was more often positive and the average level of rates was 3 percent. The relationship with rates and stock returns peaked about five years ago, but has stayed positive and has been trending higher since the trough of 13 percent in 2015.

Rising rates could hurt corporate margins, but the impact should be gradual since large-cap debt is mostly long term and fixed rate, BofAML said.

"Inflation is probably more important, and the sweet spot is 1 to 3 percent," Pouey said. The most recent reading was January's headline CPI at 2.1 percent annualized.

Leading indicators are released at 10 a.m. ET Thursday and weekly jobless claims are released at 8:30 a.m.

Earnings are expected from Barclays, Norwegian Cruise Line, Canadian Imperial Bank, Hormel Foods, Wayfair, Bloomin Brands and ovoCure. After the bell, reports are expected from Hewlett Packard Enterprise, First Solar, Wingstop, Intuit, Alliant Energy, Eversource Energy and Red Robin Gourmet Burgers.