The Tell: Rising Treasury yields take wind out of stock market amid ‘recalibration’ of Federal Reserve’s policy outlook


A selloff in U.S. government debt, inspired by the Federal Reserve’s policy update last week, finally took a toll on stocks.

The S&P 500

and Nasdaq Composite

indexes fell Monday, each headed toward their worst monthly returns since last October, while the more cyclically tilted Dow Jones Industrial Average

gained ground. Meanwhile, Treasury yields rose across the board, with the 10-year yield

trading at the highest level since June and briefly breaching 1.5%.

Rising yields tend to usually be a sign of improving economic optimism, as investors sell off government debt and shift into a more risk-on mentality. Occasionally, however, market-based rates can rise for the wrong reasons and hurt equities — such as when inflation expectations move up or the prospects of higher borrowing costs dent optimism.

In this case, traders seem to be factoring in tightening monetary policy this year and next from the Fed, even as policy makers lowered their growth expectations for 2021 and held their inflation outlook somewhat steady from 2022-2024.

Read: It May Be Time to Start Worrying About Bond Yields Again

Until Monday, stock investors had brushed off the impact of tightening monetary policy down the road — choosing to focus instead on the lack of specific details about the timing or pace of tapering.

Short-term Treasury yields began jumping last Wednesday, after Fed officials indicated that the tapering of $120 billion in monthly bond purchases “may soon be warranted” and penciled in one rate hike for 2022 — the first increase since 2018. A day after the Fed’s update, the 10-year and 30-year rates also spiked and have each climbed by roughly 15 basis points or more since policy makers clarified their plans.

“We’re seeing a short-term recalibration of the Fed’s policy outlook now that there’s clarity on tapering,” said Tom Garretson, senior portfolio strategist at RBC Wealth Management in Minneapolis.

“The market will be focused on the debt-ceiling issue for the next couple of weeks and after that we can see a return to higher yields for the right reasons,” he said, in a phone interview. “We think equities can work in that environment. Growth is still expected to pick up and higher yields for the right reasons will correlate with higher stocks for the right reasons.”

For the month, the S&P 500 is down by around 1.7%, while the Nasdaq is lower by more than 2%. The Dow is down roughly 1%.

On Monday, tech shares were leading the way lower, down 1.5%, among the S&P 500’s 11 sectors. Meanwhile, sectors that tend to do well in a rising rate environment, including energy and financials, pushed higher: The energy sector jumped more than 3%, also aided by a continued rally in oil prices.

“There are few corners of the market more vulnerable to higher bond yields than tech and long duration assets — energy and financials are the best hedges to a rising yield environment,” Chris Weston, head of research at Pepperstone, wrote in a note.

Toward the end of the year, traders will begin to shift their focus to the likely peak level for the fed-funds rate target in this cycle, said RBC Wealth Management’s Garretson. “We think 2% is the ceiling and the key number to watch for the 10-year by next year,” he said, adding that the widely watched rate will likely struggle to get to 1.75% this year.

Market Extra: What happens if the U.S. defaults on its debt?

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