Why the 10-year yield above 3% can hurt stocks

A rise in bond yields could signal more pain for stocks, especially now that the yield on the 10-year note has fallen above a critical threshold as the selloff in U.S. stocks intensified on Monday, several market technicians said.

According to Nicholas Colas, co-founder of DataTrek Research, stocks are falling because the yield on the 10-year Treasury TMUBMUSD10Y,
3.033%
is on track to close above 3% on Monday for the first time since June.

The 3% level has served as an important line in the sand for the stock dating back to the stock selloff that took place during the fourth quarter of 2018.

“It’s like clockwork,” Colas said in a telephone interview with MarketWatch. “As yields approach 3%, markets struggle. As they go above 3%, stocks fall.”

This pattern has already appeared once this year, as Colas and BTIG market analyst Jonathan Krinsky pointed out. The S&P 500 SPX,
-2.15%
it hit its lowest close of the year on June 16, just two days after the 10-year Treasury yield hit 3.48% — its highest level in more than a decade.

Years ago, stocks’ sensitivity to bond yields was rooted in the dividend yield investors earned simply by holding stocks, Colas explained. But over the past two decades, major companies have cut their dividends or eliminated them altogether as investors have come to favor stocks with the strongest prospects for revenue growth.

The dividend yield for the S&P 500 now stands at about 1.5%, according to FactSet. But that doesn’t matter as much as the huge debt load on the companies’ balance sheets.

Companies saddled with debt in the wake of the Great Financial Crisis as the Federal Reserve and other central banks, including the European Central Bank, held interest rates steady at or below zero, driving corporate leverage to new highs.

This has resulted in the amount of outstanding corporate debt for US companies rising to more than 50% of gross domestic product, Colas said. To put that in context, the initial estimate of second-quarter GDP, released last month by the Bureau of Economic Analysis, put the size of the U.S. economy at $24.85 trillion.

“When you have that much debt loaded on a balance sheet, higher yields become problematic much faster,” he said.

Rising yields are also why many market strategists expect value stocks, a group that includes companies such as JPMorgan Chase & Co. JPM,
-1.61%
and International Business Machines Corp. IBM,
-1.84%,
will continue to outperform growth stocks or a group that includes Netflix Inc. nflx,
-6.15%
and Amazon.com Inc. AMZN,
-3.59%

Simply put: stocks with less debt on their balance sheets are better positioned to outperform in a rising interest rate environment.

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“That’s exactly why you’re going to have a shift in value from growth. Companies with strong margins will probably do much better,” said Tavi Costa, portfolio manager at Crescat Capital.

U.S. stocks continued to fall on Monday after the S&P 500 snapped a four-week winning streak on Friday. The S&P 500 SPX,
-2.15%
fell 91 points, or 2.2%, in afternoon trade.

The Dow Jones Industrial Average DJIA,
-1.90%
fell 650 points, or 1.9%, to 33,055, while the Nasdaq Composite COMP,
-2.57%
fell 313 points, or 2.5%, to 12,391.

All three indexes were on track for their biggest daily declines since June. In comparison, the yield on the 10-year Treasury TMUBMUSD10Y,
3.033%
strengthened by 4.6 basis points to 3.028%.

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