- Spiking bond yields have put major pressure on stocks over the past few days as investors speculate on the negative effect higher interest rates will have on liquidity.
- Bank of America Merrill Lynch has run an analysis and pinpointed the threshold where 10-year Treasury yields should make traders reconsider their allocations to stocks.
The rationale is simple: When yields rise, bonds become more appealing to investors. And that renewed interest often comes at the expense of stocks.
In this particular case, the shift lower in equities was a long time coming, with major indexes sitting near all-time highs. Stocks slipped sharply over a period of days, also driven lower by trade-war fears.
And while equities have appeared to stabilize for the time being, there’s a prevailing sentiment that the recent sell-off was simply a dry run for when the Federal Reserve hikes interest rates further. After all, the closely-watched 10-year Treasury yield tends to climb when the Fed tightens.
In other words, this is probably going to happen again. So what are you going to do to prepare? When should you flee stocks entirely, to avoid the inevitable selling pressure?
Bank of America Merrill Lynch has run some analysis that should shed some light on the matter. At the center of the firm’s research is the so-called equity risk premium, which is defined as the excess return investing in stocks provides over a risk-free rate.
In BAML’s mind, when Treasury yields reach a certain level, stocks lose their luster relative to bonds, and it’s time to reallocate. After some thorough number-crunching, the firm arrives at 5% as the line of demarcation.
The chart below shows this dynamic in action. As you can see, historical allocation to stocks has peaked when the 10-year yield is between 4.5% and 5%. Once it climbs above 5%, equity holdings drop.
„5% is the level of the 10-yr at which our market-derived equity risk premium framework indicates that stocks trade at fair value to bonds, all else equal,“ Savita Subramanian, BAML’s chief US equity and quant strategist, wrote in a client note.
With this in mind, it’s important to remember that the 10-year is currently trading in the area between 3.2% and 3.25% — nowhere near the crucial threshold BAML has laid out.
The firm also mentions that, despite its wary outlook on what a higher 10-year yield will mean for stocks, the S&P 500 will climb another 5% from current levels over the next decade.
In the end, BAML says it’s probably not most prudent to ditch stocks altogether at any point, even if the 10-year climbs toward the dreaded 5% level. If that happens, the firm thinks it’s probably best to simply rotate out of equities towards bonds to a extent, while staying invested in both.
Source: Business insider