Whether you're a relatively new investor or someone who's been putting their money to work in the stock market for decades, one thing you'll quickly realize is there's always a bearish scenario lurking that could (key word!) lead to a crash.
In recent weeks, I've highlighted a number of these scenarios, including historically high valuation multiples for the broad-based S&P 500 (^GSPC 0.95%) and tech-heavy Nasdaq Composite (^IXIC 0.00%), and the potential for setbacks in containing the pandemic with numerous variants of the disease infiltrating select U.S. states.
But neither of these have weighed down the S&P 500 or Nasdaq Composite in 2021. Instead, it's rapidly rising Treasury bond yields that have Wall Street worried.
When the curtain closed on 2020, 10-year Treasury bonds were yielding 0.93%, with 30-year bonds paying out 1.65%. But as of March 23, 10-year Treasury bonds were yielding 1.63% and 30-year bonds were up to 2.34%. A roughly 70-basis-point move in less than three months for both the 10-year and 30-year T-bond might not sound all that interesting, but it has some wide-ranging implications that could (again, key word!) lead to a stock market crash.
Here are four reasons why rapidly rising rates might lead to market turmoil.
1. A safer return might discourage investing in stocks
To begin with, you have to understand that Treasury bonds issued by the U.S. federal government are a considerably safer investment vehicle than putting your money to work in stocks. But buying a bond yielding, say, 0.93%, isn't going to outpace inflation over the next decade.
Even though the 10-year and 30-year are only yielding 1.63% and 2.34%, respectively, this might be enough of a bounce to encourage conservative investors to sell out of stocks and buy bonds. If enough people choose the safe route, money outflows out of the stock market could send equities screaming lower.
2. Higher interest payments on loans
Another logical response of a steepening yield curve -- i.e., longer-term yields rising, while short-term yields stand pat or decline -- is an eventual increase in borrowing rates.
For its part, the Federal Reserve has pledged to keep its federal funds target rate at or near historic lows through 2023. It's also promised to continue its monthly quantitative easing measures, which involves purchasing $120 billion worth of long-term Treasury bonds ($80 billion) and mortgage-backed securities ($40 billion). Since bond prices and bond yields move inverse to one another, buying bonds should boost prices while providing downward pressure on yields.
But the central banks' ongoing easing measures haven't fazed yields one bit since 2021 began. As yields rise, the cost to borrow would be expected to tick higher. That's bad news for growth stocks that have been relying on cheap borrowing costs to fund their hiring, innovation, and acquisitions. Remember, growth stocks have been the market's primary growth driver since the Great Recession more than a decade ago.
3. Reduced corporate buybacks
To build on the previous point, higher Treasury yields could also be a recipe for fewer corporate buybacks among megacap companies.
As an example, tech kingpin Apple (AAPL 0.11%) has regularly borrowed money at historically low lending rates to fuel its aggressive share repurchase program. In February 2020, Bloomberg detailed plans for Apple to borrow $14 billion at rates that were roughly 95 basis points higher than Treasury yields. Although 70 basis points may not sound like much, it would, on paper, work out to an extra $98 million in annual interest on a $14 billion loan.
For megacap companies like Apple that have robust cash flow, the period of ultra-cheap borrowing costs may have come and gone. That might lead to a reduction in corporate share buybacks and, therefore, slower growth in year-over-year earnings per share.
4. Higher mortgage rates
A fourth reason rapidly rising Treasury yields are bad news has to do with the tie-ins between the 10-year yield and mortgage rates.
Historically, 10-year T-bond yields have been a benchmark for mortgage rates. With yields hitting historic lows in 2020, mortgage rates recently did the same. But with the 10-year bouncing more than 100 basis points off of its all-time low in mere months, it's only a matter of time before 15-year and 30-year mortgage rates follow suit.
Even though mortgage rates could rise 100 basis points from their recent lows and would still be well below their historic average, current and prospective homeowners have been spoiled by low rates for too long. Over the past decade, there were two instances where 30-year mortgage rates quickly rose by roughly 100 basis points. In each instance, refinancing and new loan origination activity fell off a cliff.
Seeing as how the housing boom has helped homeowners build equity, a rapid rise in Treasury yields could put an end to another epic rally in housing.
Here's why rising Treasury yields shouldn't worry you
While there's clearly a lot of angst surrounding rising Treasury yields, it's equally important for long-term investors not to overreact.
One thing to remember about a recovering U.S. economy is that it's perfectly normal to see a steepening yield curve. This is traditionally a sign of growing confidence in the economy, and would imply that investors are selling bonds (thereby pushing yields higher) to put that money to work in equities. More often than not, the S&P 500 advances when the yield curve is steepening.
What's more, long-term investors are acutely aware that all stock market crashes represent buying opportunities. Crashes and corrections occur frequently, but often take only a couple of months or a few quarters to resolve. Meanwhile, bull markets usually last for years, with each and every crash or correction in history having been erased by a bull market rally.
Though it's possible rapidly rising Treasury yields could cause a stock market crash, any substantial downside in equities would represent an amazing buying opportunity for investors.