• The magic number for the bond market has become 3%. 
  • That’s the next key level the 10-year yield will cross if it continues to march higher. And depending on who you ask, it’s great or terrible news for the stock market.

The bond market is fixated on one number: 3%. 

That’s the next key level for the 10-year bond yield, which rose to a four-year high of 2.95% on February 21. The yield represents a benchmark that impacts borrowing costs for companies and consumers. 

Since the recession, many forecasters have been left with egg on their faces after comparing their guesses for the yield with actual data. At every turn, their rationale for why bond prices would fall and yields would rise proved to be premature. 

Investors have recently received signs that inflation, the missing ingredient so far, is finally picking up. The big warning came via average hourly earnings in February, and was a catalyst for the stock market’s correction that month. The 10-year yield has since backed away from 3% as some of the inflation data has been more mixed. 

But the big question as the Federal Open Market Committee meets this week is how much consideration it will give to four instead of the expected three interest-rate increases this year. “If the Fed reiterates a balanced set of
risks and does not shift the median up to four hikes this year, it will likely take some of the air out of the hawkish Fed trade,” wrote Neil Dutta, the head of economics at Renaissance Macro, in a note on Monday.

Another looming catalyst for the 10-year yield is the federal government, which has poured fuel on an already booming economy by passing $1.5 trillion in tax cuts. To fund the widening deficit, Treasury is increasing its issuance of bonds — a move that would push investors to demand higher rates. 

‘A weak and inconsistent correlation’

The 10-year yield was up by less than 1 basis points to 2.85% at 10:50 a.m. ET on Monday.

Jeff Gundlach, the founder of DoubleLine Capital, forecast in January that returns on the S&P 500 this year would be negative. The median forecast among major equity strategists tracked by Bloomberg, of 2,950, predicts a 9.5% gain.

Wall Street’s so-called bond king said last week that his forecast “would become an extraordinarily strong conviction as the 10-year starts to make an accelerated move above 3%.”

Should Gundlach’s prediction come true, it would end a nine-year streak of positive annual total returns for the S&P 500.

Gundlach’s forecast may be different, but it doesn’t mean his counterparts on Wall Street are ignoring the risks that higher yields pose to stocks. The conventional wisdom is that stocks, the riskier asset class, lose some of their appeal when bond yields get more attractive. Rising yields mean it’s getting more expensive for companies to borrow. And, higher yields raise the discount rates that investors, in calculating valuations, use to determine the present value of cash flows.

Historical data shows an on-and-off relationship between stocks and bonds. Bank of America Merril Lynch examined 64 years of data to conclude that stocks have shown “a weak and inconsistent correlation” with interest rates.

Higher yields were bad for stocks for most of the period from the 1960s through the 1990s. That hasn’t been the case since the turn of the century. In fact, the best year for stocks in this cycle was 2013, when the 10-year yield jumped by more than 100 basis points in the taper tantrum.

There’s one caveat that BAML’s Savita Subramanian added: the probability of stock-market losses start to increase as the 10-year crosses 3%, although stocks generally stay positive until it hits 6%.   

Technical analysts at Societe Generale contend that the 10-year year is unlikely to hit 3% altogether. 

“The late accelerated downtrend (price) has brought the 10y UST near the make-or-break level of 3.00%/3.05%, the channel that has contained the broad uptrend since the 1990s,” Stéphanie Aymes, the head of technical analysis, said in a note on Monday. :”All things being equal, oversold indicators render the 3.00%/3.05% break level rather unlikely.”

SEE ALSO: The bond market is firing warning shots about the US economy

Join the conversation about this story »

NOW WATCH: I quit cable for DirecTV Now and it’s saving me over $1,000 a year — here’s how I did it