Investors Shouldn't Fear Rising Bond Yields Yet

NYSE Traders
Getty Images

With the Federal Reserve moving closer to pulling back on monetary stimulus, a rise in 10-year Treasury yields has made investors nervous. But it will take a bigger move to kill the equity market's run up, Wall Street pros say.

"The Fed is floating the trial balloon of slowing down its purchases, and the market is digesting that news," Gary Flam at Bel Air Investment Advisors said of the recent swings in equities. "Up until about a month ago, tapering was seen as a big negative. If anything, the market may now believe [tapering] is not a bad thing and could be a positive."

With Chairman Ben Bernanke and other Fed officials hinting that a pullback in bond-buying may be coming sooner than expected, yields on the benchmark 10-year note have moved above 2 percent.

Andrew Burkly at Oppenheimer & Co. said the recent steepening of the yield curve is "generally an early-cycle indicator the bond market is sniffing out better growth."

But the recent move still should keep investors on alert.

"This is a little bit of a nervous market," Flam said. "A measured rise in yield would be good for the market and financials especially."

A spike in yields, however, could spell trouble for stocks, he said. "If we go a couple of weeks and get to 2.5 percent [on the 10-year Treasury]—that type of move would be fairly dramatic."

Getting to 2.5 and above by the end of the year would be less worrisome, Flam added. "A slow grind higher in yields would be a positive sign of an increasing pace of economic activity versus market failure."

(Read More: On Second Thought ... Maybe Fed Tapering Won't Be So Bad)

Pimco's Bill Gross doesn't expect that relationship to hold, however.

"The correlation between stocks and bonds up until 2008 was a negative one in which when bond prices went down, stock prices went up—at least as a reflection of real growth," he told CNBC. "There's going to be a mild positive correlation. If bond prices go down, stock prices should go down as well.

"That's simply because the global [leveraged] trade is dependent on a stable Japanese yen and a stable JGB yield and a stable Treasury yield. Once you produce instability, that leverage starts to unwind, the housing market gets affected and stocks come down," Gross said.

Economic data come back into focus tomorrow with a revised first-quarter reading on gross domestic product, pending home sales for April and weekly initial jobless claims.

Economists expect first-quarter growth of 2.5 percent, according to estimates from Reuters, while pending new-home sales are seen rising 1.1 percent. Jobless claims should come in at 340,000 for the week ended May 5, unchanged from the prior week.

While good data may push up yields, Richard Bernstein at Richard Bernstein Advisors isn't concerned about stocks. Bond yields have risen since reaching a trough last summer, and the stock market has still advanced sharply, he noted.

"This notion that rising rates will kill the equity market is a kerfuffle," Bernstein told CNBC. "It's been happening already and it doesn't stop the market. I'm not quite sure why people are so scared that the potential for long-term rates to go up."

(Read More: Here's How the Party Will End If the Fed Pulls Back)

The sign of a looming bear market isn't a steepening yield curve, he said. Instead, it's when the Fed overtightens on policy and the yield curve inverts: meaning short-term rates move above long-term ones.

"We're no place near an inverted yield curve," Bernstein said.

With rising bond yields high-yielding defensive stocks such as utilities and telecoms have been hit hard. They are down 9 percent and 6 percent, respectively, over the past month.

"The valuation got rich in those areas, and now the rate that you're discounting the meager earnings growth is going up and it actually looks more expensive," as interest rates rise, Burkly at Oppenheimer said.

He advocates getting more exposure to cyclical areas as the market corrects. Financials in particular benefit from the steepening yield curve as it helps fatten up their net interest margins, a measure of the profits they earn from their lending activities.

(Read More: Dow 28,000 Possible in 6 Years: BlackRock's Fink)

Wall Street's preference for cyclicals has become more pronounced as strategist and investors see better economic growth ahead.

"You have a lot of the cyclicals that are on sale," Christopher Wolfe of Merrill Lynch's private bank said. While the overall market looks stretched, there are opportunities beneath the surface, he said, "and that's part of how we're thinking about this market going forward, is that you're going to have to be more nimble."

By CNBC's Justin Menza. Follow him on Twitter @JustinMenza.