The 10-year Treasury yield still has higher to go before it threatens the stock market, strategists say

Published Fri, Feb 19 202110:43 AM ESTUpdated Fri, Feb 19 202112:29 PM EST

Patti Domm @in/patti-domm-9224884/@pattidomm

Rising interest rates are beginning to worry investors, but strategists say they still have some room to rise before shaking up stocks. The quick move-up in bond yields in the past week has spooked some investors, but the equity market could run into more headwinds if yields rise close to another half percentage point, according to Bank of America strategists. The yield level the strategists say could generate turbulence for stock holdings is 1.75%, still well above Friday's level of 1.31%. "We think that's the level where correlations between risky assets and rates do begin to change empirically," said Mark Cabana, head of U.S. short rate strategy at Bank of America. "That is where you see the S & P 500 begin to pay a dividend that is substantially below what the 10-year will offer," he said. "It's going to be a headwind." Wall Street strategists disagree on exactly what level of the benchmark 10-year yield would be too high for stocks to continue to rise. Some say 3% is the historic level to watch since bonds would siphon more funds from stocks at that level. But others say it is the speed of the increase, not the level, that matters, especially since rates have been so low. A rapid rise The rapid rise of the 10-year yield rattled stocks this week. The stock market moved lower Thursday as investors assessed a move in the 10-year yield from about 1.15% in the middle of last week to 1.31% by Thursday morning. But as yields slipped back below 1.30%, stocks recovered some of their losses. Stocks were higher Friday, and the 10-year was again at 1.31%. The 10-year is especially important since mortgage rates and other loans are impacted by its yield. Cabana said he expects the 10-year yield to reach 1.75% by year-end. He said that forecast was revised from 1.5% after the Jan. 5 runoff election for two Georgia Senate seats that gave Democrats a majority in Congress. The Biden administration's proposed $1.9 trillion stimulus package is winding its way through Congress, and a large package is expected to be approved. Cabana said the Treasury market has to catch up with improving expectations for the economy, and that's driving yields higher. "It's just a reflection of the fact that there will be ongoing improvements in growth, Covid will end, stimulus will flow," Cabana said. "You're going to see a market that is much less focused on downside risk, and you're going to see a market that is focused on neutral balance for risk, and then an upside assessment," he said. "We haven't been in that position in a long time." S & P 500 dividend yield vs. the 10-year Treasury The dividend yield of the S & P 500 is 1.5%, still well above the 10-year's yield. Cabana and other strategists say that could be a level that starts to unnerve the stock market. But the 1.75% level will be an even bigger draw for investors seeking yield, Cabana added. "Bonds just become attractive at that point. If you're getting the same type of yield, there's less upside, but bonds offer better portfolio diversification if you're worried things are frothy right now" in the stock market, Cabana said. There are 239 companies in the S & P 500 that currently have dividends below 1.31%, according to a CNBC study. That's the level the 10-year was trading at Friday. "The S & P dividend yield is about 1.5%. We would suggest that relationship is probably when the 10-year yield starts to trade above the S & P 500 dividend yield," said Julien Emanuel, BTIG head of equity and derivatives strategy. "That's likely when the market encounters difficulty. It's hard to say that's going to happen at 1.5%, 1.75% or 2%," he added. Bank of America stock strategists note the stock market can still rise as yields rise, and stock returns were positive in 13 of the last 15 rate-hiking cycles. However, as rates go higher, the attractiveness of stocks versus bonds fades. " Five percent [10-year yield] is the level at which stocks trade at fair value to bonds, all else equal. 5% is also when the reward-to-risk ratio for stocks vs. bonds skews favorably toward bonds," the BofA strategists noted. Cabana said as yields rise and the economy improves, the Fed could begin discussing an end to some of its easing practices, such as its bond purchases. Such talks could kick off as early as late spring to summer, depending on Covid numbers and where the economy stands, he said. "We think the Fed is going to set the stage for a taper at the end of this year," he said. "We think they will taper in the first quarter. The market doesn't really care about when it starts to taper, it's when the Fed signals it." — CNBC's Nick Wells contributed to this story.

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Rising interest rates are beginning to worry investors, but strategists say they still have some room to rise before shaking up stocks.

The quick move-up in bond yields in the past week has spooked some investors, but the equity market could run into more headwinds if yields rise close to another half percentage point, according to Bank of America strategists.

The yield level the strategists say could generate turbulence for stock holdings is 1.75%, still well above Friday's level of 1.31%.

"We think that's the level where correlations between risky assets and rates do begin to change empirically," said Mark Cabana, head of U.S. short rate strategy at Bank of America.

"That is where you see the S&P 500 begin to pay a dividend that is substantially below what the 10-year will offer," he said. "It's going to be a headwind."