The Rebound in Bond Yields Could be Bad for Equities

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Morgan Stanley Chief Us Equity Strategist Mike Wilson believes that the market is at a risk for recovery.

Morgan Stanley Chief Us Equity Strategist Mike Wilson believes that the market is at a risk for recovery, according to Business Insider.

The 10-year Treasury yield has started to climb. The pre-pandemic yield was at 1.8 percent and dipped as low as 0.5 percent. Now, the yield is around 0.66 percent. "The 33% increase in 5 days is the third largest on record," Morgan Stanley Chief US Equity Strategist Mike Wilson said, referring to 10-year Treasury yields. "The two largest moves occurred in March and early June of this year. We don't think this is a coincidence and may be indicative of a bigger shift under the surface that is largely underappreciated."

Wilson believes the upward momentum in treasury yields could be detrimental for equity valuations as investors shift back into bonds from equities.

Wilson believes bond yields will continue to rise for these 5 reasons.

  1. Massive monetary and fiscal-policy responses are stronger than they were during the Financial Crisis and should contribute to the economic recovery.
  2. Another stimulus package would bolster the first point and insinuate that deficits are normal for the US economy.
  3. Last week, the 30-year bond auction was met with week demand after the Treasury Department increased the offering to a record.
  4. If the Fed sets a target for average inflation at their next meeting, it could result in longer-term yields falling since they wouldn't have to rise in correspondence with expected inflation.  
  5. Lastly, the recent surge in cyclical and defensive stocks may signal a rise in 10-year yields.

"Such a rise could prove to be very challenging to many equity portfolios that likely embed higher long duration risk than may be appreciated," Wilson said. "If such a scenario unfolds, we think it could lead to a correction in the primary equity indices given the long duration nature of all equities and revaluation that has occurred due to falling rates."

However, Wilson noted that a correction would be followed by a bull market since 10-year yields rising is a sign of economic growth and inflation. Wilson believes banks, diversified financials, capital goods, energy, and materials would all benefit from this shift.

"While this result is not all that surprising, the correlations to real yields and breakevens among these groups are worth noting. Cap Goods, Energy, and Materials are more levered to higher breakevens, whereas changes in real yields are really not significant in terms of explaining relative performance," Wilson said. "Meanwhile, Financials tend to benefit when either breakevens or real yields rise."

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