After a skirmish that sent the stock market into its first correction in two years, equities and the bond market are once again at peace. The question for investors is whether the truce can hold.
The stock market plunge took the S&P 500 (.SPX) and the Dow Jones Industrial Average (.DJI) into correction territory, dropping from an all-time high on Jan. 26 to a more-than-10% pullback with breathtaking speed last week — a move ostensibly triggered as the 10-year Treasury yield scooted above 2.80% in early February. Yields and bond prices move in opposite directions.
This week, stocks found their footing to take back around three-quarters of the lost territory, even as the 10-year yield resumed its climb to top 2.94% on Thursday for the first time since early 2014 earlier this week.
For some, the market's resumed comfort with rising yields simply acknowledges that yields, by historical standards, remain low.
"When you put this yield move in the context of current economic numbers, this doesn't seem like the end of the world. We anticipate a grind higher in yields with not too much volatility, and expect the stock market to continue to do well," said Alessio de Longis, portfolio manager for OpperheimerFunds' global multiasset group.
For the most part, bond yields and stocks have moved in tandem, a principle undergirding diversified portfolios, with investors finding a cushion from bond performance when stocks fall. Last week's turmoil, however, saw both stock and bond prices falling at the same time, at least initially, before a flight to quality pulled yields back down temporarily.
The underlying worry is that once rates travel high enough — or simply rise fast enough — the bond market's weakness can turn into a source of stress for stocks. After all, low yields have been cited as a justification for historically stretched stock market valuations.
Also, rising yields can signal fears of mounting inflation pressures, which could push the Federal Reserve to raise interest rates more aggressively, raising the risk of a policy mistake that could throw the economy into recession. Torsten Slok of Deutsche Bank noted the negative correlation between stock and bond prices tends to disappear when price pressures threaten.
Yet this time around it only took a few days before the two asset's relationship swiftly reverted back to their norm.
Investors admitted the rapid speed at which yields rose was worrisome, but they remained historically low given the current economic backdrop. The flurry of fiscal stimulus measures including a $1.5 trillion tax cut is expected to boost growth to a 3.0% pace this year, while January saw the strongest inflation reading since 2005.
With inflation-adjusted interest rates and inflation expectations below historical averages, the stock market could handle a 10-year yield above 3%, an important psychological level, said de Longis.
The real yield—the difference between the nominal yield and inflation expectations—stands at 0.82% on the 10-year note, a two-year high, but still historically subdued. Inflation expectations as measured by Treasury-inflation protected securities were 2.05% on Feb. 13.
Before the financial crisis, the 10-year real yield lingered around 2%, while inflation expectations flitted between 2.00% and 2.50%. This would add up to a nominal yield of around 4.0%, said de Longis, suggesting rates had room to run higher.
Others like J.P. Morgan strategist Mislav Matejka agree with the view that low real rates won't prevent the stock market from rebounding. In a Monday note, he said that equities rarely saw a downturn when real yields were below 2%. Higher inflation-adjusted interest rates, however, can crimp the corporate bottom line by increasing borrowing costs.
Matejka was confident "the negative correlation between stock and bond prices is not dead, in our view, it will quickly re-establish itself and ultimately provide a valuation cushion in case of future equity weakness."