Markets Need A 30% Stock Drop Or 50% Higher U.S. Yields. Or Not.

The S&P 500 is near a record high, and global bonds have rallied for 5 straight months. The benchmark 10-year Treasury yield, at 2.20%, is close to its 2017 low. One of those investor groups has to lose. The US Treasury will be under-financed by as much as $4.5 trillion over the next 5 years, and will have to issue more debt. To find enough demand, interest rates would have to climb 120 basis points from current levels, or equity prices would have to plunge 30%.

The comments above & below is an edited and abridged synopsis of an article by Brian Chappatta

The sharp move in rates may play out because price-insensitive bond buyers like the Federal Reserve are leaving the market, foreign investors may step back as their own central banks tighten policy, and pensions can’t justify buying Treasuries unless yields are higher.

In the meantime, stocks and bonds are rallying when their hedging power against one another is strong. In May, investors added about $6 billion to bond mutual funds, extending a streak of inflows that began in January. At the same time, they’ve yanked money out of domestic stock funds in 12 of the past 13 weeks.

The correlation between the S&P 500 and the Bloomberg Barclays U.S. Treasury Index in the past 30 days is the lowest since July 2016. A more negative reading signals prices are likely to move in the opposite direction of one another, providing a stronger hedge. As recently as mid-April, the figure was positive.

The best example of this hedging strength at work was May 17, when the S&P 500 plunged 1.8%, its biggest drop since September. Treasuries, by contrast, rallied the most since July 2016.

The fact that both markets are rallying even with this offsetting dynamic at work suggests that investors are buying both sides as a way to offset their exposure to losses. For now, that trade is paying off, thanks to fund flows and trends in economic data and company earnings.

The bond market is growing more skeptical about the sustainability of higher inflation. Meanwhile, with the earnings season drawing to a close, 78% of S&P 500 members have exceeded profit forecasts and 63% have beaten sales expectations.

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