- Rising rates are not a problem for stocks right now, but they do create some level of concern in the market.
- Strategists say Treasury yields are climbing on stimulus and the outlook for better growth, but if they increase too quickly it would hurt the stock market.
- Investors should look at more cyclical sectors, including financials, as rates rise.
Rising interest rates can set off alarms in the stock market, but strategists say be prepared, not afraid.
For now, interest rates are rising with the idea that inflation will also go higher.
But the alert right now is probably more like a smoke alarm and one burnt frying pan, rather than a house on fire.
"This is less about the absolute level of yields and more about the speed at which it takes to get there, and at this point, we're not concerned with the speed," said Julian Emanuel, chief equity and derivatives strategist at BTIG.
The most closely watched yield is the benchmark 10-year Treasury, which influences mortgages and other loans.
It was lower Tuesday at 1.16%, after touching the key 1.2% level Monday. At that level, strategists say it would be headed for 1.25%, which could launch another break higher. In late January, the yield, which moves opposite price, hit a trough of 1%.
Yields on the way up
Bond pros say yields are headed higher, and they are rising for several reasons.
One big factor is Covid fiscal stimulus, the $900 billion approved in December and the $1.9 trillion plan now making its way through Congress.
Better growth is expected because of the federal money, but that also results in more debt, and potentially inflation. That's another reason for higher yields.
Emanuel of BTIG said he would be concerned if the 10-year yield started to race higher. He expects it to reach 1.7% by the end of the year.
However, if it moved too quickly, stocks could hit a rough spot. For instance, a danger zone would be about 1.34% if the 10-year yield were to reach that level as early as this month.
"That would likely be a headline that would cap the market's rise and cause further rotation away from high multiple growth stocks and into cyclicals and value," said Emanuel.
"Cyclicals, in particular, could absorb this kind of rotation and keep the market moving sideways," he added. "The same speculative interest that the public has shown in technology stocks ... it's entirely possible that at some point in 2021, you could get a degree of speculative fervor that you've seen in those types, moving towards financials."
The S&P financial sector is up about 6% since the start of the year.
Banks have moved higher as the yield curve has steepened. That simply means the difference between short-term rates, like the 2-year, and longer-term rates, like the 10-year, has increased.
That so-called steeper curve helps banks to make money, as they can borrow at the very low short-term rates and lend at a higher rate for longer periods of time.
Bank of America strategists say energy and tech hardware are among the expensive sectors that could be hurt by rising rates. Banks, diversified financials and semiconductors are among inexpensive sectors that benefit from rising rates, they added.
Stock dividends vs. yields
But strategists say Treasury yields, though rising, are far from levels where they compete with stocks for investment dollars.
Lori Calvasina, head of U.S. equity strategy at RBC, said there's no set level on the 10-year that's a negative trigger for stocks but "3% feels like it's where people in the past tended to get concerned."
Calvasina said she monitors the number of companies in the S&P 500 paying dividends above the 10-year yield. At the beginning of the year, 63% of S&P 500 companies had dividends above the 10-year yield, and several weeks later it was at 56%.
"If it falls to 20% or 30%, at that level the market could begin to struggle," she said. If the market does not run into trouble at that point, there are still issues and investors see less forward return.
The rising rate and inflation trade is very much the value-cyclicals rotation that began in the second half of last year, as vaccine news was positive and investors started to look forward to a more normal economy in 2021.
Inflation expectations have been rising but they are still low.
The 10-year breakeven, which is a market-based inflation measure, was at 2.20% on Tuesday, up from about 2.1% at the beginning of last week. That means that investors are betting that inflation will average 2.2% over the next 10 years.
Calvasina of RBC said as rates rise and inflation expectations increase, investors should stick with the reflation trade.
The reflation trade is when investors bet on companies that will do well when the economy improves and reopens. This includes airlines, financials and industrials.
Calvasina also said she likes the financial sector, but some investors are under the misconception that parts of the reflation trade are already baked in.
Energy may be up more than 15% with the rise in oil prices this year, but other cyclical sectors, like materials and industrials, are up just about 2% since the start of 2021.
Growth areas in technology and communications services could be used as a funding source for the rotation, since they have done well, Calvasina said.
"As inflation expectations are rising, you tend to see the underperformance of tech, the underperformance of communications services. The parts that tend do well are the commodities and financials," she added.
Jonathan Golub, chief U.S. equity strategist at Credit Suisse, says he does not expect tech to get too hurt as rates rise. But the stocks to buy in this environment are among the "junkiest."
"I don't think tech will get choked. I think the better way of looking at it, is who wins the most from an improving economy. The answer is cyclical companies ... and companies that have a business problem," he said. "You want someone who is on the precipice, smaller cap, companies that have lots of debt."
Golub also said that rising Treasury yields are also positive for the market, since they represent an improving economy.
"The most stimulative event in the history of the planet will not be the end of World War I, the end of World War II, it will be the reopening of the economy this summer," he said.