With 10- and 30-year Treasury yields surging and U.S. equities fighting to hold onto gains, bonds are starting to look a lot more appealing.
But a flight to the safety Treasuries might not be the best move – at least not yet, Bank of America Merrill Lynch analysts said.
“When do equity investors go back to bonds? There is no magic number, but if we had to pick: 5%,” analyst Savita Subramanian wrote in a new research report.
Based on several tested frameworks to determine the 10-year yield breakpoint where bonds look more attractive than stocks, 5% came out as the consensus, the analysts said. The rate is “the level of the 10-yr Treasury bond yield at which Wall Street’s average allocations to stocks peaked” and is their expected return of the S&P 500 over the next decade, Subramanian added.
“If the 10-yr Treasury, the so-called ‘risk-free’ rate, climbs to the level of expected equity returns, the decision between stocks and bonds would be clear cut,” the analysts said.
Other experts point to lower thresholds for stocks to underperform. Credit Suisse analysts including Jonathan Golub said in a September note that stocks will move positively with yields until rates reach 3.5%, while CFRA investment research analyst Lindsey Bell cited a level of 4%.
The yield on the 10-year Treasury note climbed above 3.25% in early trading Tuesday, hitting its highest level in seven years. The 10-year yield has gained more than 20 basis points over the last week after key economic indicators showed the U.S. unemployment rate at its lowest level in nearly 50 years along with steadily rising wages. The 30-year Treasury bond yield rose above 3.43% to its highest level since 2014.
Rising bond prices have pressured stock prices, with the S&P 500 and Nasdaq posting losses every day since last Wednesday. The S&P 500 is still up more than about 8% this year.
Improved economic conditions have raised concerns that the Federal Reserve would push borrowing costs back toward more normal levels after a long period of low rates following the 2008 financial crisis. Some investors worry that higher rates will lead to an economic slowdown and hamper corporate profits, causing market volatility.
“Last week’s message across markets was loud and clear — yields are rising but growth will likely slow next year, which means portfolios need to shift,” Michael Wilson, Morgan Stanley’s chief U.S. equity strategist, wrote in a research note.
While the “Fed model” – or the theory comparing the stock market’s earnings yield to the yield on long-term government bonds – shows equities “losing their luster,” the Bank of America analysts cautioned against looking at current market conditions through that lens.
“The problem with the Fed model is that its predictive power is close to zero,” the analysts said. “We think stocks, especially large caps, are attractive amid rising rates based on historical analysts and the output of our other models. Rising rates are amore definitive reason to sell bonds, in our view.”
Emily McCormick is a reporter for Yahoo Finance. Follow her on Twitter: @emily_mcck
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