The S&P 500 tumbled 0.68% yesterday t0 2,711. The proximate reason for this is that the yield on 10-year US Treasuries surged to 3.08%. The reason why the stocks tumble as Treasury yields rise is straightforward.
The 10-year US Treasury yield is effectively the risk-free rate that most analysts use to get the present value of future cash flows. Accordingly, that makes it critical to valuing stocks, bonds and virtually every other financial asset.
In this case, rising 10-year Treasury yields decreased the value of future cash flows. Subsequently, that knocked stock prices down.
However, this is likely just the start of rising Treasury yields and falling stocks. Treasury prices (which have an inverse relationship to Treasury yields) will continue to fall in the coming quarters as …
Surging Treasury Supplies To Swamp Demand
The US government has gone on a $1.2 trillion spending binge at the same time that Trump has cut $1.5 trillion in taxes. This is blowing out the budget deficit. Indeed, it is projected to grow steadily from $668 billion last year to more than a trillion dollars by 2020.
The US government will need to finance this debt by issuing vast amounts of new debt in the form of US Treasuries. However, debt markets will have a tough time absorbing this tidal wave of new debt.
Indeed, US Treasuries demand is shrinking as the Federal Reserve (Fed) continues to ramp up its tapering program. Come October, the Federal Reserve will decrease its holdings by $50 billion per month. Or to put it another way, debt markets will need to soak up another $600 billion worth of financial assets including US Treasuries.
Rising supplies and shrinking demand will naturally push Treasury prices lower. Or to put it another way, Treasury yields will rise to coax investors to buy up the ever-increasing supply.
How Far Will Stocks Tumble As Treasury Yields Rise?
The 10-year Treasury yield is up about 0.6% since the start of this year. At this pace, the 10-year Treasury yield could easily rise to 4% over the coming year as new issuances increase.
A slow steady rise will create manageable headwinds for the stock market. Similar to what we’ve seen yesterday.
However, as yields close in on key levels, like 3.5% and 4%, investors will take note. Particularly, if these moves happen in a sudden, sharp manner.
Indeed, this is precisely why the market corrected by about 10% in early February. Accordingly, investors should prepare for another 10% or greater correction as we breach key levels.