This month's rise in long-term interest rates has heightened investors' concerns about the future of the stock market.
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U.S. Treasury yields hit a new 2024 high last week as the latest data showed inflation is likely to persist. Wall Street traders had expected the Federal Reserve to cut interest rates six times this year.Now they Price with just one. The yield on the 10-year Treasury note, a benchmark that rises as bond prices fall, is up nearly 1 percentage point from its February lows and closed Friday at 4.668%.
Many are concerned that a rebound in yields could derail further profits, especially when stock prices are relatively expensive relative to corporate earnings. Rising yields will cause stock prices to plummet in 2022, reducing the additional returns investors receive in exchange for the added risk of holding stocks instead of bonds, and reducing the amount of money Wall Street imposes on companies' future profits. It has lost its present value.
Tensions fully eased on Thursday, with weaker-than-expected U.S. economic growth data and stronger-than-expected inflation, sending stocks lower and yields surging. But stocks rallied on Friday, helped by strong earnings from companies including Google's parent company Alphabet and the Fed's preferred inflation measure.
“The Fed's interest rate cut in March and its sixth rate cut this year is disappointing, to say the least,” said Rick Rieder, chief investment officer of global fixed income at $10.5 trillion asset manager BlackRock. It was overheating,” he said. “Now that thought process has been completely reworked, and when you do that, the market becomes very excited for what’s next.”
Traders will get a fresh look at the outlook for interest rates from Fed Chairman Jerome Powell at the end of Wednesday's central bank meeting. All eyes will then turn to Friday's jobs report for clues about the health of the economy. The Treasury is also expected to release its latest quarterly borrowing plan this week, giving investors a breakdown of how the government will borrow to close its budget deficit.
Steve Sosnick, chief strategist at Interactive Brokers, said many companies largely ignored rising yields this year as the strong economy boosted corporate profits. That's one reason the S&P 500 closed Friday about 2.9% below its all-time high on March 28. It continues to rise by 6.9% for the year.
However, this increase has expanded valuations. S&P 500 companies traded Friday at about 24 times trailing 12-month earnings, well above the 10-year average of about 20 times. Thursday's report also suggested that a combination of slower growth and higher-than-expected inflation could mean the outlook is bleaker than most expected.
“The reason stocks were able to withstand rising yields is because they were predicated on a strong economy,” Sosnick said. “This one seems more worrying. If inflation spooks the bond market even more, that's going to be a problem.”
Other challenges lie ahead for bonds. The U.S. government has been selling new bonds at a record pace, raising concerns that the market will struggle to absorb the rush of inflows. This month, a selloff triggered by positive expectations for the consumer price index intensified after weak demand for a $39 billion 10-year Treasury bond sale. Rising short-term bond yields have also made long-term bonds less attractive, increasing bond volatility.
David Kelley, chief global strategist at JPMorgan Asset Management, said a confluence of factors has made the outlook less optimistic than bullish investors had hoped for at the beginning of the year, but the outlook remains strong. He said it was far from a disaster.
“We still believe that the economy is gradually slowing and that inflationary pressures are gradually easing,” Kelly said. “There's a lot of activity in the market, and it doesn't hurt to have some steam in that regard.”
On Friday, enthusiastic investors once again rushed into big tech, the bedrock of the recent market rally. The communications services sector of the S&P 500 index soared 4.7%, with Alphabet and Microsoft posting big gains as they reported profit growth.
If interest rates remain high, the more speculative parts of the market and the stocks of some highly valued tech companies will give Mr. Kelly pause.
“Over time, high interest rates will undermine some of the most bogus bets being made in financial markets,” he said. “Cryptocurrencies, gold or some of the growth stocks that benefit from low interest rates over the long term. I think they're all vulnerable.”
Many on Wall Street still expect yields to fall by December as inflation slows again. Economists at Goldman Sachs have dialed back their expectations for rate cuts, but still expect two cuts this year.
BlackRock's leader believes yields are likely to fall by the end of the year, as the Fed has lowered or shown signs of lowering its benchmark interest rate. But in the near term, he expects volatility to continue and yields to potentially rise sharply.
“My sense is that interest rates will go down by the end of the year, but in the short term people are being cautious. There's a lot of uncertainty,” Rieder said.
Email Jack Pitcher at jack.pitcher@wsj.com.
