The 10-year U.S. Treasury yield just topped 5% for the first time in 16 years, according to the Wall Street Journal. Rising bond yields correspond to falling bond prices, so upward momentum in Treasury yields points to selling pressure in the market -- and that pressure has been persistent.
The 10-year U.S. Treasury yield has climbed 110 basis points year to date, 350 basis points since the beginning of 2022, and 400 basis points since the beginning of 2021. Other Treasuries have followed a similar trajectory, and the broader Treasury market is on pace for its third consecutive annual loss, according to Bloomberg.
Investors need to understand why that is happening, and what it could mean for the stock market. Here are the details.
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A combination of factors are pushing Treasury yields higher
Rising bond yields correlate with falling demand, so the first question investors need to ask themselves is: Why is demand for U.S. Treasuries falling? Experts point to a combination of factors.
First, the Federal Reserve has fought inflation with aggressive rate hikes. Policymakers have pushed the federal funds rate -- a benchmark that impacts other interest rates across the economy, like mortgages and credit cards -- to its highest level since 2001. When interest rates rise, investors expect higher bond yields, so demand slips for existing bonds until their yields reach market levels.
Second, while countless analysts called for a recession in 2023, U.S. economic growth has actually outpaced the long-term average, according to Fed Chairman Jerome Powell. That resilience has dashed hopes that policymakers will quickly pivot to rate cuts. Instead, investors now assume rates will remain elevated through 2024, reinforcing their expectation for higher bond yields.
Third, the government is selling more Treasuries to cover a wider-than-expected deficit, and the Fed is letting bonds roll off its balance sheet to drain liquidity from the banking system (which will theoretically help curb inflation). The former increases bond supply and the latter reduces bond demand, both of which drag on prices and push yields higher.
Higher Treasury yields could mean trouble for the stock market
The next question investors need to ask themselves is: How will rising Treasury yields impact the stock market? Ian Lyngen of BMO Capital Markets says stocks could suffer a broad downturn, echoing sentiment from other experts. That would be a logical outcome. Treasuries offer risk-free returns, and that proposition becomes more attractive as yields rise, making it more likely that investors pick bonds over stocks.
For context, the 10-year Treasury yield last topped 5% in June 2007 -- just a few months before the Great Recession -- and the stock market suffered a colossal decline shortly thereafter. The S&P 500 (^GSPC 1.02%) slipped 10% over the next 12 months, and it tumbled 38% over the next 24 months.
Of course, the Great Recession was brought on by excessive lending to subprime borrowers, while the current situation was largely caused by excessive stimulus and supply shocks amid a global pandemic. It's hard to compare the two. But the fact remains that rising yields make U.S. Treasuries an increasingly compelling investment, and that could shunt capital away from the stock market in the near term.
History says patient investors need not worry about bond market drama
There are several plausible trajectories the stock market may follow in the coming months. The S&P 500 could soar to record highs if rising yields fail to lure investors away from equities and the U.S. economy remains resilient. Alternatively, the S&P 500 could nosedive if investors flee to safe-haven assets and the U.S. economy crumbles under the weight of higher borrowing costs.
The near-term outlook may be murky, but history says there is only one plausible outcome in the long run. The S&P 500 will continue to climb higher and create wealth for patient investors. The index has suffered numerous corrections, bear markets, and recessions in the past, and it has recovered from every single one. More than that, it has returned about 10% annually over long periods of time, and investors have no reason to believe that will change.
In that context, patient investors need not worry about the bond market drama, and now is no time to avoid stocks, though a little caution may be prudent. Investors unsure where to put their money should consider an S&P 500 index fund.
I'll close with a quote from Wall Street legend Peter Lynch: "Far more money has been lost by investors trying to time corrections than has been lost in all the corrections combined."
