How high yields could go from here and what it means for stocks

Published Tue, Sep 28 20212:18 PM EDTUpdated Tue, Sep 28 20215:19 PM EDT

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

The closely watched 10-year Treasury yield is breaking out, and that could have big implications for some of Wall Street's favorite tech stocks. How much higher the benchmark yield will go is up for debate. Some strategists say the 10-year yield could rise above this year's high of around 1.76% before the end of 2021, and Pimco says it could go as high as 2%. The 10-year yield's rise is closely tied to the stock market, and its move higher has had a negative affect on tech and growth stocks, which tend to fall as the yield rises. That is because investors count on those stocks for future growth and cash flow, and as rates rise the value of that cash flow declines or is discounted. The 10-year yield was as high as 1.56% on Tuesday, up about a quarter of a percentage point from where it was when the Federal Reserve met Wednesday . The Nasdaq was down 2.8% on Tuesday. Alphabet and Microsoft each fell more than 3%. The ARK Innovation Fund dropped 4.2%. Yields had fallen off the year's highs in March and April amid resurging Covid, worries about a slower economy and technical factors. The 10-year yield reached as low as 1.12% in early August. But rising inflation and the Fed are among factors sending yields higher, as Covid cases appear to be ebbing and the economy is expected to improve. "I think the correction in yields is over unless there's some other exogenous thing happening in the markets," said Jim Caron, head of macro strategies for global fixed income at Morgan Stanley Investment Management. "We reasserted the trend ... toward higher yields and that could lead to a break up above this year's highs in yields above 1.75%." Morgan Stanley has a target of 1.8% by year-end. The Fed was a catalyst behind this recent move, and many bond pros had expected to see an initial run in yields to between 1.55% and 1.60%, from a level of about 1.31% just after last week's meeting. The move in yields has been global, as other central banks also signal they are ready to move away from easy policies. Bond strategists say enough has changed in the last week to put the rate onto a higher trajectory back to where it was earlier in the year and then some. But all things considered, interest rates will still be rather low, and the Fed only expects its own fed funds target rate to reach 1.75% by 2024. The Fed last week signaled it was getting close to ending its bond-buying program. That means the central bank will gradually reduce the $120 billion monthly purchases of Treasury and mortgage-backed securities. It also released a more aggressive rate hike forecast, with half of officials expecting at least one rate hike next year. Since then, Fed Chairman Jerome Powell warned Tuesday that higher inflation could last longer than previously expected. Pimco sees the 10-year in a range between 1.5% to as high as 2% this year. "It's a resetting if you want to call it that ... a return to the previous range, widely expected to be in a zone of 1.5% to 2%," Pimco portfolio manager Tony Crescenzi said. "What typically happens in the stock market is it worries about the speed of the move and the destination but when the yield climb slows and eventually halts, then the stock market looks at the absolute level and starts to worry materially less because the profit outlook is quite good." Crescenzi said the stock market will adjust and move higher, and stock investors could be comfortable with the 10-year in a 1.5% to 2% range. "We would be in the camp of overweight equities for the next one to two years because of the bright outlook for the U.S. and global economy," he said. "We expect GDP to be in the zone of around 4% next year. That's quite a good number with double digit earnings growth for the S & P 500." Rising rates aren't all bad, and higher yields, as long as they don't rise too quickly, could give investors more confidence about the economic recovery. BMO fixed income strategist Ben Jeffery said the move points more to a growth-related move than an inflationary one. The stock market's sell off could also act as a dampener on the yield move, meaning the sell off could send investors looking for safety in bonds. Jeffery said his next target is 1.60% on the 10-year, and then 1.70%. "If we get meaningfully close to 1.70%, there's going to be some pretty significant buying interest." BTIG head of equity and derivatives strategy Julian Emanuel said he's staying with his forecast of a 2% yield for the 10-year by year-end. "The issue for the stock market is less about direction and more about speed." Emanuel added that, if Washington does not pass a spending bill and rates continue to rise, it would signal the stock market is worrying about inflation. A concern for stocks would be if the 10-year yield returned to the 1.75% zone it was at earlier this year. "Above the year's high at 1.77% is a signal to the market that the abnormally low era of interest rates has officially ended," Emanuel said. He has been expecting a stock market correction, but says the market could resume its climb in the fourth quarter. Crescenzi said other forces have also been at work to send yields higher. For instance, in September there's typically a large amount of corporate issuance, so buyers move to that market from Treasurys. Pension funds have also been becoming more fully funded with the rise in stock prices, so they are replacing some of those equity holdings with longer duration bonds. "What's motivating some investors to sell is persistence - the persistence of somewhat higher inflation evident again in the run up in energy prices and in all the commotion about shipping problems," Crescenzi said. "There's persistence in the supply side problems, persistence in longer term inflation expectations and also a persistent Fed. It is marching forward with its plan to taper and eventually tighten. The taper doesn't set a date for tightening, but the clock starts ticking once the taper begins." Crescenzi said he expects inflation to start to decelerate next year. "There are already a lot of rate hikes priced in so there isn't much additional boost to yields that is likely to be tied to the Fed," he said. He said the move in the 10-year yield could be contained, just by the impact of higher interest rates. "The more the yield rises, the more likely it causes spillover effects into other markets. That spillover causes investors to move back toward bonds and it stabilizes," he said. He added that foreign investors will continue to find higher U.S. yields attractive.

A trader works on the floor of the New York Stock Exchange (NYSE) in New York, on Monday, Sept. 20, 2021.

Michael Nagle | Bloomberg | Getty Images

The closely watched 10-year Treasury yield is breaking out, and that could have big implications for some of Wall Street's favorite tech stocks.