ANALYSIS - Rising Treasury Yields Test U.S. Stocks on Rich Valuations

By Lewis Krauskopf

NEW YORK (Reuters) - A rise in Treasury yields could be the latest test of a rebound in U.S. stocks that has made them increasingly expensive while taking them to record highs.

While Treasury yields have accelerated in recent weeks, expectations that the Fed will cut interest rates this year helped the S&P 500 Index gain 10% in the first quarter. Valuations have also risen: the benchmark index trades at just over 21 times forward earnings estimates, the highest since January 2022, according to LSEG Datastream.

Now, strong economic data is weakening expectations for the central bank to cut interest rates this year. The 10-year bond yield, which is inversely proportional to bond price movements, reached 4.4% on Tuesday, the highest level in more than four months.

So far, a strong economy, solid corporate earnings and enthusiasm for artificial intelligence have helped the stock market largely withstand this year's rise in yields. However, some investors worry that high valuations could make stocks more vulnerable if interest rates continue to climb. In addition to raising the cost of capital for companies and households, higher yields compared to equities could also increase the attractiveness of "risk-free" Treasuries.

"[Yields] broke through previous ceilings, and that's troubling," said Chuck Carlson, chief executive officer of Horizon Investment Services." The trend in these rates is troubling because what you're seeing here is a series of higher highs that continue to move higher, and those highs are continuing today."

In recent years, rising yields have helped the stock market fall a number of times, selling off in September and October when the 10-year yield surged to a 16-year high of just over 5%, only to roar back up when yields reversed. 2022 saw the S&P 500 plummet 19% as the Fed quickly raised interest rates to stop the surge in inflation, and on Tuesday the S&P 500 dropped 0.7% while the 10-year yield was last around 4.35%. On Tuesday, the S&P 500 lost 0.71 TP3T, while the 10-year bond yield was last at about 4.351 TP3T.

One of the key reasons investors are optimistic about a rise in yields this year is that the Fed has signaled its intention to cut rates in 2024. But strong economic data has left investors skeptical that the central bank will be able to ease rates as previously expected.

Tuesday's futures market showed that investors expect a rate cut of about 70 basis points this year, compared with more than 150 basis points in January. This is lower than the central bank's estimate of 75 basis points for the year.

At the same time, various measures suggest that stock market valuations have become less attractive.

The equity risk premium, which compares the S&P 500 yield to the yield on the 10-year Treasury note, turned negative in the first quarter for the first time since 2002, said Keith Lerner, chief investment officer at Truist Advisory Services.

"Bonds offer some real competitive opportunities," says Ed Clissold, Matrix U.S. Market Strategist at Ned Davis Research. So if we see 10-year Treasury yields soar as much as they did in the swing days of last year at 5%, equities may reflect that, and equity valuations will need to come down."

Some investors think the correction is overdue. According to Bank of America Global Research, the S&P 500 has not fallen significantly since October, although historically it has averaged three retracements of 5% or more per year.

"We've been anticipating a 3-5% reversal for months," says Paul Nolte, senior wealth advisor and market strategist at Murphy & Sylvest Wealth Management." We may finally be on our doorstep."

The reaction of equities to rising yields may depend on whether investors continue to believe that the underlying economy remains strong and inflation continues to cool.

Damian McIntyre, director of multi-asset solutions at Federated Hermes, said that if the rise in yields "is due to much stronger economic growth than expected, then investors will be receptive to that." " But if growth starts to slow and inflation climbs, then investors will start to worry.

Friday's U.S. jobs data will be a test, and if the report is stronger than expected, yields could continue to rise. Earnings growth for the S&P 500 is expected to be around 10% this year, according to LSEG IBES.

"Stocks can stand up to a lot of tests if there are earnings," says Horizon Investment Services' Carlson." But if earnings don't continue to beat expectations and interest rates now rise to four-month highs, that will be a problem for the market.

(Reporting by Lewis Krauskopf; Additional reporting by David Randall; Editing by Ira Iosebashvili and Richard Chang)