The Stock Market Is Ignoring This Threat

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For the past two months, markets have shrugged off any negativity: conflict in the Middle East, rising oil prices and inflation, the growing possibility that the Fed could raise interest rates, etc.

Any news is good news. Major indexes have enjoyed a meteoric rise as a result.

But one key part of the market is offering us a warning right now. So today, let’s see why it’s telling us there could be trouble ahead…

An Economic Brake

After a period of consolidation, U.S. 10-year Treasury yields burst higher this month. Just recently, they pushed through 4.6%.

The reason this matters for consumers is that the 10-year Treasury yield acts as a benchmark for a wide range of borrowing costs – from mortgages and business loans to corporate bonds, auto loans, and even credit cards.

So when Treasury yields rise, borrowing costs usually rise too. That acts like a brake on the economy. Spending slows, refinancing becomes more expensive, and businesses become more cautious about expansion.

But the clampdown on economic activity doesn’t stop there…

For investors, rising yields also put pressure on stock valuations – especially for high-growth technology stocks.

Stocks are valued on the present value of their future cash flows. But those future cash flows become less valuable when yields rise – meaning that future earnings are worth less in today’s dollars.

That particularly affects tech and growth stocks, given that much of their cash flows are expected to come in later years.

Rising yields also play a part in where investors park their funds…

Correction in the Cards

When bond yields are low, investors see little return on their investments in safe-haven assets (such as government bonds). They turn to riskier assets (like stocks) to spruce up their returns.

But as Treasury yields push up into the 4.5%-5.0% range, that starts to change the equation. Investors can earn a decent return on government bonds. Like much in the markets, it comes back to risk versus return…

Large funds and institutions begin moving capital out of risk assets into the relative safety of bonds. And when large pools of money shift between asset classes, the rotation can have a significant impact on prices.

At the same time, inflation pressures are building. Oil prices remain elevated, and geopolitical risks point to more challenging times ahead. Those factors are still working their way through the economy.

That increases the risk that rates will stay higher for longer, and we could even see a rate hike ahead, which the market is now factoring in.

Put all this together, and you can start to see this rally is facing some major fundamental issues… The higher that bond yields go, the greater the chance that a correction comes into play.

So don’t trust this rally. I recommend taking some profits, hedging your positions, and tightening up your risk management.

Because when the bottom starts to fall out, it could happen quickly…

Regards,

Larry Benedict
Editor, Trading With Larry Benedict