Bond yields surge’s potential impacts on the equity market
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Key Takeaways
- The sharp rise in Treasury yields has caught the market’s attention
- Earnings growth should be the catalyst to drive the S&P 500 higher
- Investor overoptimism remains the biggest risk overhanging the market
Hello 2025! US equities had a stellar 2024, with the S&P 500 up 25%, but the year ended on a softer note. The sharp rise in bond yields has caught the market's eye, with the 10-year Treasury yield climbing over 100 basis points since the Fed started cutting interest rates last September, with nearly half of that increase happening since early December. Despite this, the S&P 500 has largely weathered the storm, gaining over 5% since the Fed began its easing cycle, driven by robust economic growth and rising earnings. Yet, as we enter 2025 with equity gains stalling and yields pushing higher, two key questions arise: Can equities sustain their momentum in the face of higher interest rates? And at what point do higher yields pose a challenge for the equity market? Here are our thoughts on the recent bond yield surge and its potential impact on the equity market:
Treasury Yields Remain Front And Center | Treasury yields continue to march higher, with the 10-year yield now up a stunning 100+ basis points since the Fed’s first rate cut—surpassing last April’s peak (4.7%). Key drivers of the rate increase include:
- Resilient Economic Growth—The economy has not skipped a beat since the Fed preemptively cut rates to preserve growth. In fact, the US economy is on track to end 2024 with solid momentum (Atlanta Fed 4Q24 GDP Now: +2.7%) and growth expectations are marching higher for 2025—helped by Trump’s pro-growth (i.e., tax cuts, deregulation, America First) initiatives. At the same time, inflation has proven stickier than expected. Case in point: The Prices sub-index of the ISM Services survey recently ticked up to nearly a 2-year high. These dynamics have led to a major reset in Fed rate cut expectations, with only one cut (rather than the four previously) expected in 2025.
Our View: The US economy is resilient although we expect GDP to slow slightly to 2.4% this year from 2.7% last year. The slowing will be evident in job creation as the pace of monthly job growth will slow from ~190k to ~140k. Inflation should continue to decelerate and approach 2%, especially early in the year due to favorable base effects and lower energy and shelter prices. Tariff risks appear overblown.
- Fiscal Worries Ramp Higher—Market anxiety around Trump’s spending plans amid an already unsustainable fiscal trajectory has put upward pressure on bond yields. This week’s $119bn worth of new Treasury supply was a lot for the market to absorb—driving yields modestly higher to entice buyers. These worries will linger as there remains uncertainty about how much the new administration’s policy initiatives will add to the deficit (currently at ~6% of GDP) and growing level of debt (which recently surpassed $36t).
Our View: With the debt ceiling reinstated, there could be a temporary reprieve as there will be no new debt issuance until Congress lifts or suspends it again. In addition, all of the expected spending initiatives of the new administration are not likely to be passed as there will be pressure to focus on containing the growth rate of the deficit. With yields currently stretched to the upside, we suspect there is limited further upside in the near term. Currently, we see no signs of the appetite for Treasuries waning as the bid-to-cover ratios remain at or above 2.5x.
What Do Higher Rates Mean For The Equity Market? | We view the 4.5% level on the 10-year Treasury yield as a defining line for risk assets—particularly as the S&P 500 is flat since the 10-year crossed that threshold. The recent rise in interest rates is important for a few reasons:
- Investor Sentiment Could Slip—We have long flagged investors' bullishness on the stock market. In fact, investors are the most bullish they have ever been on equites as over 50% of investors expect stock prices to rise over the next 12 months. But with the 10-yr Treasury yield now comfortably above 4.50%, mortgage rates are back above the key psychological 7.0% level. This should not only weigh on confidence but could become a headwind for the housing market and overall economy. If investors start to fear another economic growth scare, they could sour on the equity market again—leading to another pullback. And with interest rates attractively valued relative to equities (10-yr Treasury yield higher than the S&P 500 Earnings Yield) keeping an eye on investor sentiment in the equity market will be crucial.
Our View: Overoptimism was our biggest risk for the equity market coming into the year. Any disappointments regarding the economy, earnings, the Fed, or policy will instigate periods of volatility. The 10-year Treasury yield is not dramatically above our year-end 4.50% target.
- Higher Rates Could Start To Weigh On Valuations—Multiple expansion has been the driver of the equity market over the last few years. In fact, P/E expansion has accounted for ~75% of the gains since the bull market began in October 2022. Historically, P/E multiples are inversely related to yields, meaning higher yields are associated with lower multiples. Of note, each time the 10-year Treasury yield crossed the 4.3-4.5% threshold, multiples flatlined or started to decline. And with yields now above 4.5%, this could pose a headwind for equity markets.
Our View: Valuations to start the year were trading at an elevated level at 25x trailing earnings. We expect a modest retreat in multiples to 23.5x. The bigger catalyst for the equity market will be 13% earnings growth. With 4Q24 earnings season beginning next week, confidence in a strengthening and broadening earnings environment should be supportive of our year-end S&P 500 target of 6,375. Selectivity will remain critical so focus on sectors with strong earnings growth and less sensitivity to interest rates—Technology, Industrials, and Health Care.
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