By Lewis Krauskopf
NEW YORK (Reuters) - The fate of an early year rally in stocks may depend on whether equities can withstand a recent rise in U.S. Treasury yields, as investors increasingly come around to the Federal Reserve's higher-for-longer mantra on interest rates.
Yields, which move inversely to prices, fell to start the year, after hitting the highest level in more than a decade in late 2022. They have shot higher in recent days, however, following a strong U.S. employment report that led investors to recalibrate expectations for how high the Fed will need to raise interest rates to keep inflation moving lower.
Comments from Fed Chairman Jerome Powell on Tuesday did little to dissuade markets from the notion that the central bank will raise rates higher than investors had previously priced in and keep them elevated for longer, as he said rates may need to move higher than expected if economic strength threatens the Fed's progress in lowering inflation.
On Tuesday, rising yields did not appear to undermine the appetite for stocks. The S&P 500 rose 1.3% along with a 6 basis points rise in the 10-year U.S. benchmark Treasury yield.
Some investors worry, however, that a continued repricing of rate expectations could weigh on equities in coming weeks, after a rally that has seen the S&P 500 gain 8.5% year-to-date and the Nasdaq Composite rise 15.7%. Last year, both logged their biggest annual percentage drops since 2008.
Falling yields have "definitely been a key support for the market and if we lose that, that will be a trigger for volatility," said Angelo Kourkafas, investment strategist at Edward Jones. "We don't think that rally is built on sand ... but maybe the speed could prove a little premature if we do see an uptick in yields and interest rates."
The yield on the benchmark 10-year Treasury note has increased nearly 30 basis points to 3.69% since last Wednesday. The yield on the two-year U.S. note gained almost 40 basis points to 4.47% since last Thursday.
Higher bond yields dull the relative appeal of stocks while raising companies' borrowing costs. Higher Treasury yields can also weaken the valuations of equities in standard valuation models, particularly for tech and other companies that rely on future profits that are discounted at higher rates when yields rise.
The equity risk premium, or extra return investors expect to receive for holding stocks over risk-free government bonds, has become less favorable over the past week, according to data on Tuesday ahead of Powell's comments from Keith Lerner, co-chief investment officer at Truist Advisory Services.
The current premium coincides with a 12-month excess return of 3.5% for the S&P 500 over the 10-year Treasury note, but the premium has fallen closer to a level that would suggest a more diminished return, according to Lerner.
Futures markets on Tuesday were pricing in a peak Fed funds rate of 5.12% in June or July, falling to about 4.8% by December. Prior to last Friday's employment report, they had expected the Fed funds rate to peak at 4.88% in June.
DATA IN FOCUS Following Powell's comments, investors are shifting focus to economic data, with two consumer price index reports -- including one due next Tuesday -- and another jobs report expected before the next Fed meeting. "The market is in a bit of a more comfortable place after chairman Powell's comments to be able to digest the gains that have already been seen this year and then wait for more data to come in," said Yung-Yu Ma, chief investment strategist at BMO Wealth Management. Meanwhile, some investors are not yet worried about the threat to stocks from yields. Brian Jacobsen, senior investment strategist at Allspring Global Investments, said yields are not likely to hurt equity markets unless the 10-year yield rises back above 4%, a level it has not breached since November.
Jacobsen is bullish on growth stocks, which were squashed by higher yields last year but have staged a strong rebound in 2023. "Most of the profit recession is behind us and investors can start positioning for a profits recovery," Jacobsen said.
(Reporting by Lewis Krauskopf; additional reporting by Karen Brettell and David Randall; editing by Ira Iosebashvili and Jonathan Oatis)
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