Goldman: Don't worry about rising interest rates until the 10-year yield hits 4%

Key Points
  • "Lower equity prices are not an inevitable consequence of higher interest rates," David Kostin of Goldman Sachs writes in a note. "We expect negative valuation changes if the level of rates approaches 4%."
  • The benchmark 10-year Treasury note had a yield of 3.07 percent on Monday.
  • The 10-year yield has risen about 71 basis points for the year through Friday as investors fear the Fed could tighten monetary policy faster than expected.
  • Goldman told clients to buy certain financial stocks to play rising rates.
David Kostin
Scott Eells | Bloomberg | Getty Images

U.S. interest rates have shot up to levels not seen in years recently, giving stock investors a new concern. But a Goldman Sachs strategist says it's not time to worry just yet.

David Kostin, Goldman's chief U.S. equity strategist, wrote in a note Friday that investors should not worry about rising borrowing costs and their effect on stock valuations until the 10-year Treasury yield zeroes in on 4 percent. The benchmark note yielded 3.07 percent on Monday.

"A rise in interest rates should lead to a fall in equity prices, all else equal. An equity's value is equal to the present value of a perpetual stream of future dividends, which are highly sensitive to the discount rate," said Kostin. "However, lower equity prices are not an inevitable consequence of higher interest rates. We expect negative valuation changes if the level of rates approaches 4%." He also said stock prices could take a hit before that level is reached if rates rise too rapidly.

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Yields have been rising as investors fear that inflationary pressures in the U.S. will lead the Federal Reserve to tighten monetary policy at a faster pace than expected. The 10-year yield hit 3.11 percent last week — its highest level since 2011 — while hovered around a near-decade high.

"The actual impact of interest rate changes on equity prices depends on the reason interest rates are rising. If interest rates rise in anticipation of faster economic activity, this could lift growth expectations and also lower the equity risk premium," noted Kostin.

The 10-year yield had risen about 71 basis points year to date through Friday, Kostin points out. Stocks, however, have weathered the sharp rise in yields thus far. Entering Monday's session, the and Nasdaq composite were up 1.5 percent and 6.5 percent for the year, respectively, while the Dow Jones industrial average is flat. The small-caps Russell 2000, meanwhile, hit an all-time intraday high Monday and is up 6,6 percent in 2018.

"Assuming no valuation change, strong earnings and dividend growth will lift the S&P 500 index to our year-end 2018 target of 2850," said Kostin.

The strategist added he recommended investors overweight the financials sector, which benefits from rising interest rates. Financials highlighted by Kostin include Bank of America, Wells Fargo, State Street and Capital One Financial.