Interest Rates and Their Potential Impact on Equities

Key Takeaways

• The repricing of rate cuts further out on the calendar has pushed 10-year Treasury yields higher. Technically, the next major area of overhead resistance sets up at the 4.35%–4.40% range.
• Higher yields captured most of the blame for Tuesday’s equity market decline. However, it is not all bad news. Market expectations and Federal Reserve (Fed) monetary policy projections have become closer aligned, alleviating a source of market volatility. Furthermore, better-than-expected economic data has been a driving force of the market’s repricing of rate cuts, reducing the likelihood of a hard-landing scenario.
• If yields continue higher, defensive sectors and international equity markets could notice a deterioration in relative strength, as they have been the most negatively correlated to 10-year yields over the last year. In contrast, these areas of the market could also witness an uptick in relative performance if yields pull back from their recent highs.

Investors have been playing a game of "how high will they go?" with Treasury yields this month. Better-than-expected economic data and Tuesday’s uptick in core consumer inflation have repriced Federal Fed rate-cut expectations further out on the calendar. Fed funds futures are now pricing in June as the most likely scenario for the first cut, as implied probabilities for a 25 basis-point rate cut in May are only around 50%. As a result, Treasury yields have shifted higher across the curve.

While higher yields captured most of the blame for Tuesday’s equity market sell-off, it is not all bad news. First, the gap between market expectations for rate cuts this year and Fed projections — a source of both equity and fixed income market volatility — has finally started to narrow. The market currently has priced in about four 25-basis-point (0.25%) cuts by year end, down from almost seven in January. The market is now only one cut away from the three cuts penciled in by the Fed during their December Summary of Economic Projections. Second, lowered expectations for rate cuts have been primarily underpinned by the economy doing better than expected. Of course, this raises inflation risk and the prospect for higher-for-longer monetary policy, both factors the market has successfully been dealing with over the last year.

Turning to the charts, 10-year yields have recaptured resistance from the January highs and 200-day moving average, leaving the 4.35%–4.40% range (prior highs/key retracement level) as the next major overhead resistance area. As highlighted below, yields have started to pull back from this area in the aftermath of Tuesday’s Consumer Price Index report. Support sets up at 4.20% and 4.12%.

While momentum indicators have turned bullish, trend strength remains questionable. As noted in the bottom panel of the chart below, the positive directional movement index (+DMI) crossed above the negative DMI (-DMI), pointing to a change in trend direction. However, the Average Directional Index (ADX) — used to measure trend strength (calculated from a smoothed average of the difference between the +DMI and -DMI) — remains low.

How High Will They Go?

Jump in 10-year Treasury Yields Hits Resistance

Source: LPL Research, Bloomberg 02/15/24
Disclosures: All indexes are unmanaged and cannot be invested in directly. Past performance is no guarantee of future results. 

Market Impact

With yields near a key area of overhead resistance, a breakout or breakdown from here could create many different outcomes for equity markets. To understand the impact of higher or lower rates on stocks, we analyzed the correlations between 10-year yields and several major market indexes and S&P 500 sectors. The table below breaks down each correlation.

As the table illustrates, higher rates would likely act as a headwind for the broader equity market landscape. Defensive sectors, such as utilities, consumer staples, and real estate may experience a deterioration in relative strength if yields break out, as they have been the most negatively correlated to yields over the last year. At the index level, global markets could also lag if yields continue higher. The MSCI All-Country World Index ex-USA is the most negatively correlated broad-market index to 10-year yields. In contrast, these areas of the market may experience an uptick in relative performance if yields pull back from their recent highs.

Correlation Comparison: 10-year Treasury Yields & Equity Markets

Source: LPL Research, Bloomberg 02/15/24
Disclosures: All indexes are unmanaged and cannot be invested in directly. Past performance is no guarantee of future results. 

Summary

Rising Treasury yields have recently run into a key area of overhead resistance. A breakout above the 4.35–4.40% range would not only be technically significant but also create headwinds for the broader equity market. If yields continue higher, defensive sectors and international equity markets could notice a deterioration in relative strength, and vice versa if yields pull back. Overall, starting yields for many fixed income markets are still at levels last seen over a decade ago, and LPL Research views the return prospects for fixed income as favorable and maintains its 3.75% to 4.25% year-end 2024 target for the 10-year Treasury yield.