How the rapid run-up in interest rates could set off a 10% to 15% correction

Published Thu, Feb 18 20212:15 PM ESTUpdated Thu, Feb 18 20214:22 PM EST

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

Rising interest rates are rattling the stock market, and that could be the catalyst for a bigger sell-off, strategists say. Stocks tumbled on Thursday, but the market closed off its lows. The Dow Jones Industrial Average shed 119 points, or 0.4%, and the S & P 500 was down 0.4% at 3,913. The Nasdaq closed down 0.7% at 13,865. The 10-year Treasury yield was at 1.29% as stocks sold off, after trading as high as 1.31% earlier in the day. The yield was about 15 basis points – or 0.15% – lower in the middle of last week. Julian Emanuel, chief equity and derivatives strategist at BTIG , said the stock market could be in the middle of a 10% to 15% correction, after the rapid run-up in interest rates that took the 10-year to fresh one-year highs. The sell-off would have been more like 5% to 10% pre-pandemic, he said. "The market is sufficiently overbought that that spot may be closer to the 200-day moving average which is 3,418," said Emanuel. He said the market will adjust to the higher yield, and the sell-off should create a buying opportunity. "It's definitely a change in psychology that as we found, and rightly so, given the greater success of the vaccine and pretty reasonable prospects for the economy," he said. "You're seeing this shift away from growth and toward value stocks. That shift hardly ever occurs in the course of history in a non-volatile fashion." Art Hogan, chief market strategist at National Securities, said the stock market should not be reacting as much as it is to the current level of yields. "It's the pace of change, not the actual place we've gotten to that investors are worried about," he said. "We think the yield on the 10-year will be between 1.5% and 2% by the end of the year. We just didn't think it would be there by the end of this week." Hogan said the move in rates is likely due to the view that the economy will improve and that Covid is going to come under control. "If that's the case, it's likely a positive for equities, not a detriment. That worry decreases when we don't see [yields] going up 20 basis points in a week," he said. The benchmark 10-year yield i s the most widely watched Treasury rate. It influences mortgages and other loans. Besides higher borrowing costs, the concern is if rates rise too much, higher yields will lure investment dollars out of the stock market and into the bond market. The dividend yield on the S & P 500 is about 1.5%. "You shouldn't freak out every time the yield on the 10-year goes up, thinking it's the apocalypse because it's not. We're near an all-time high. To me this is an excuse to take profits," Hogan said. The pullback could be as steep as 10% or more, he said. "The shift higher and market psychology around what has been a rise in yields, not just in the U.S. but globally suggests at these valuations, the oversold market is going to have difficulty sustaining these levels in the near term, particularly for high-multiple growth stocks," said Emanuel of BTIG. He said both institutional and retail investors are overexposed to high growth names. "That's a source of pressure because as interest rates rise, the value of the discounted cash flow in these companies…decreases," Emanuel said. "That wouldn't be a problem at 15 or 20 times next year's earnings, but for many companies, with 30, 40, 50 and upward times valuations, it's a significant headwind in the near term." That would include a number of FAANG stocks. For instance, Facebook was down about 1.6% on Thursday afternoon at 2 p.m. ET. Netflix was nearly 0.9% lower and Alphabet was down 0.6%. Other growth favorites Apple lost 1.7%, while Tesla was down 1.5%. The bond market is also pricing in more inflation, and strategists say investors have been keeping an eye on that. Higher prices are showing up in some data, but economists do not see a big spike in inflation, nor do they expect the Fed to react yet. In this week's data, import prices were higher Thursday, jumping the most in nine years in January in part due to energy prices. January's producer price index data, which was released on Wednesday, showed the biggest surge in wholesale inflation since 2009. "People are now waking up to this inflation story," said Peter Boockvar, chief investment officer at Bleakley Advisory Group. "If there's one thing to stop a run that was predicated by low interest rates, it's higher interest rates. When rates reverse, it'll be time to take a breather here." The 10-year breakeven, a bond market inflation measure, was at 2.19% Thursday. That suggests investors expect inflation to average 2.19% over the course of 10 years. The Fed has targeted an average range for inflation around 2%.

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Rising interest rates are rattling the stock market, and that could be the catalyst for a bigger sell-off, strategists say.

Stocks tumbled on Thursday, but the market closed off its lows. The Dow Jones Industrial Average shed 119 points, or 0.4%, and the S&P 500 was down 0.4% at 3,913. The Nasdaq closed down 0.7% at 13,865.

The 10-year Treasury yield was at 1.29% as stocks sold off, after trading as high as 1.31% earlier in the day. The yield was about 15 basis points – or 0.15% – lower in the middle of last week.

Julian Emanuel, chief equity and derivatives strategist at BTIG, said the stock market could be in the middle of a 10% to 15% correction, after the rapid run-up in interest rates that took the 10-year to fresh one-year highs.

The sell-off would have been more like 5% to 10% pre-pandemic, he said.