The sharp rise in bond yields is forcing traders to consider that they may be holding two irreconcilable ideas in their heads.
One is that the Federal Reserve has no real control over bond market interest rates. The other is that the Fed can keep the stock market aloft as long as it tries to control interest rates.
The resilience of share prices — the S&P 500 rose 5.8 percent in the first quarter — suggests that those two ideas can coexist. But if yields continue to rise, the impact on companies, consumers and homeowners and the appeal that fatter bond yields may have to investors could produce a reckoning for stocks.
“The bond market is at an inflection point that eventually is going to be recognized by the stock market,” said Komal Sri-Kumar, president of Sri-Kumar Global Strategies. “Over the last 30 years, the bond market has only gone one way, but a change is occurring now, and it’s likely to be an abrupt one.”
How abrupt the rise in yields will be, and when the stock market bears the brunt of it, could depend on the breaching of certain levels of interest rates and how the Fed responds. While the Fed controls short-term interest rates, it has been far less powerful in the bond market. And Mr. Sri-Kumar thinks a 2 percent yield on the 10-year Treasury bond, which ended the first quarter at 1.75 percent, would begin to make stock investors uncomfortable.
Luca Paolini, chief strategist at Pictet Asset Management, thinks the Fed and Wall Street have a bit more wiggle room. It usually takes a while before rising yields lead to deterioration in stocks, he said.
“As long as the U.S. economy continues to improve, I don’t think rising bond yields will be a real problem,” he said. “But it’s important for the increase to be gentle. The level where you can get a real problem for equities is around 2.5 percent.”
Trouble also may arise when the Fed ultimately decides that it’s time to tell the markets that tighter monetary policy is coming.
“It’s not so much the level of bond yields but the ability of the Fed to send a signal at the right time,” Mr. Paolini said. “If they postpone it, they’re going to pay for it. The stock market will be higher and risk will be greater.”
The market went sufficiently higher in the first quarter to send the average domestic stock fund up 7.3 percent, led by portfolios that focus on energy, smaller companies and especially financial services, according to Morningstar.
The average international stock fund rose 3.1 percent, with specialists in China and India doing noticeably well.
It was a different story for bond funds. The average one fell 1.1 percent, with modest strength in high-yield portfolios partially offsetting a 14.1 percent drop in long-term government funds.
Olga Bitel, global strategist at William Blair, said she is unconcerned about rising yields because she views them as resulting from stronger economic growth, not higher inflation. In fact, she would be worried if rates weren’t rising under these conditions.
“If real growth is going to be much higher, interest rates need to move higher for inflation rates to stay muted,” she said. “On current growth expectations, it would make sense by the end of summer for rates to be 2 percent to 2.2 percent just on growth expectations.”
For James Paulsen, chief investment strategist at the Leuthold Group, economic prospects could hardly be better.
Growth “could challenge the best ever in postwar history,” he said during a conference call in which he offered his outlook for the next few months, including a forecast of 8 percent higher economic output this year.
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“There is just so much here that is continuing to stimulate it,” he said. “We’ve got some juice behind this recovery.”
Mr. Paulsen envisions “a bloody year for bonds,” but he thinks the S&P 500 could reach 4,400 this year, nearly 11 percent above its March 31 level, although he warned that there could be “a nasty correction” of perhaps 15 percent along the way.
As for the economy overheating and generating inflation, he thinks it’s coming, but not yet.
“That’s not an issue for 2021,” he said.
But some data suggest it could be an issue soon. The Consumer Price Index rose 0.4 percent in February, according to the latest Labor Department report, giving it a 1.7 percent increase for the preceding 12 months. The figure has been rising steadily toward the 2 percent target set by the Fed, although the Fed has indicated that it would be willing to see that level exceeded for brief periods.
Big spending continues in Washington, even as the coronavirus pandemic seems to be abating. After passage of a $1.9 trillion bill last month to help the economy after the ravages wrought by the pandemic, President Biden proposed spending $2 trillion more on infrastructure projects, albeit over several years.
That $4 trillion, give or take, would be “going into an economy saturated with $6 trillion of stimulus spending from the Trump administration,” Mr. Sri-Kumar said. So much spending is likely to push up inflation and bond yields, he said.
Michael Hartnett, chief investment strategist at Bank of America Global Research, does not expect such concerns to diminish soon.
Because of such factors as “new central bank mandates, excess fiscal stimulus,” as well as “less globalization, fading deflation from disruption, demographics, debt, we believe inflation rises in the 2020s and the 40-year bull market in bonds is over,” Mr. Hartnett said in a report.
Commodities and other hard assets should outperform in the long term, in his view, along with shares of smaller companies, value stocks and foreign stocks. The dollar, shares of big companies and bonds should do worse.
David Giroux, a portfolio manager and head of investment strategy at T. Rowe Price, said he is worried that the bill will come due for much of the government spending.
“There’s a high likelihood we will have higher corporate taxes next year,” Mr. Giroux said. “That will be a headwind for corporate earnings.”
That persuades him to avoid shares of economically sensitive companies for which “a lot of really good news is already priced in.”
He prefers “stocks with really good business models that have been left behind,” including technology giants that are off their highs, such as Amazon and Google, and companies like utilities. Other favorites include regional banks such as PNC and Huntington Bancshares.
Ms. Bitel at William Blair foresees long-term higher returns by big growth stocks. But she throws in an immense caveat: Because rising interest rates tend to force down valuations, especially on the most expensive segments of the market, there could be a sharp decline before the erstwhile Wall Street darlings excel again.
“Retail investors will be able to buy their favorite growth stocks at a 40 percent discount, but that leadership will resume,” she said, emphasizing that the 40 percent was a ballpark figure.
Ms. Bitel also suggested holding foreign stocks, in particular shares of Chinese health care companies and Japanese software companies.
Mr. Paolini recommends banks, energy and real estate, and said he is avoiding carmakers, industrial companies and home builders.
Considering the investment landscape more broadly, he said, “The outlook for the next one to three years is quite good.” Then he seemed to try to talk himself out of that belief.
“The idea that you can simply print money and everything is fine isn’t sustainable,” Mr. Paolini said. “At some point, we will realize too much has been done and the market is too high, and the situation will change quite fast. I don’t know what that level is or how far away we are from it.”