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Treasury yields continued their march higher on Wednesday, with the 10-year Treasury reaching 4.9% for the first time since 2007 in a move that sent stocks lower.
And while market history suggests stocks should rally into year-end, the continued sell-off in bonds is threatening to destabilize what's so far been a strong year for equity markets.
As investors sell bonds, prices fall and yields rise. And as this year's sell-off in the bond market deepens, the approach towards a big, round number like 5% for the 10-year yields can serve as a psychological magnet for investors, much the same way Dow 30,000 offered a gravitational pull for investors back in 2020.
But it's not so much the absolute level that shakes markets as it is the speed of the change in prices and rates.
That's because bonds are expected to be the boring, stable part of a portfolio that doesn't move much. After all, Treasury bills, notes, and bonds are considered "risk free."
Except a lack of worry the US government will pay you back isn't the same as expecting the value of these securities to hold steady over time. A lesson investors are relearning during the Federal Reserve's rate-hiking cycle.
Moreover, this move in the Treasury market comes as the stock market's rally remains hyper-focused on a few key stocks known now as the "Magnificent Seven."
In a note on Wednesday, Torsten Sløk, chief economist at Apollo, noted the price-to-earnings (P/E) ratio for the S&P 493 — which excludes Apple (AAPL), Alphabet (GOOGL, GOOG), Microsoft (MSFT), Amazon (AMZN), Meta (META), Tesla (TSLA), and Nvidia (NVDA) — has been steady at around 19 all year. (Disclosure: Yahoo Finance is owned by Apollo Global Management.)
For this smaller group of stocks, however, their collective P/E has risen more than 50%, to 45 from 29. In other words, investors aren't actually more excited about the prospects for most companies, just for a few.
"What is particularly remarkable is that the ongoing overvaluation of tech stocks has happened during a year when long-term interest rates have increased significantly," Sløk wrote. "Remember, tech companies have cash flows far out in the future, which should be more negatively impacted by increases in the discount rate."
Now, expectations for the cash flows of this "Magnificent" group in the future may be lofty, but these companies throw off huge sums of cash today as well. Still, in Sløk's view, this rally led by tech companies is "inconsistent" with the rise we've seen in yields.
"In short, something has to give," Sløk continued. "Either stocks have to go down to be consistent with the current level of interest rates. Or long-term interest rates have to go down to be consistent with the current level of stock prices."
There are, of course, myriad other reasons stock prices and risk-taking in general could suffer in an environment of inflation uncertainty. Or benefit should the outlook grow more stable.
But the bottom line for investors is that the longer the rise in yields persists, the greater the chance that the Fed makes a policy error by not tightening enough or by tightening too much.
All of which increases the chance that the Fed breaks something — and just what that might be we'll only know in hindsight.
Read more inflation coverage:
Inflation: Consumer prices rose 3.7% over last year in September, matching August's increase
Fed can stay 'patient' after inflation data as odds rise on a December rate hike
Gas price increases eased but still 'major contributor' to September inflation print
Housing costs again frustrate the Fed’s efforts to curb inflation
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