Treasury yields continued their upward climb on Wednesday, with the 10-year Treasury hitting 4.9% for the first time since 2007, leading to a dip in stock prices. This persistent bond sell-off now threatens the otherwise robust year experienced by equity markets, despite historical trends suggesting a year-end stock rally.

As investors shed bonds, prices decline and yields rise. This year’s bond market sell-off intensifies, and the approach to a significant milestone like the 5% mark for the 10-year yields holds a psychological grip on investors, similar to how Dow 30,000 did in 2020. However, what truly ripples through the markets isn’t just the absolute yield level but the swiftness of the price and rate fluctuations.

Bonds are traditionally viewed as the steady, uneventful component of a portfolio – the “risk-free” assets. Nevertheless, the belief that the U.S. government will honor its obligations doesn’t guarantee that these securities’ values remain stable, as investors are discovering amid the Federal Reserve’s rate-hiking cycle.

Furthermore, this movement in the Treasury market coincides with the stock market’s fixation on a select group of key stocks known as the “Magnificent Seven.” Torsten Sløk, the chief economist at Apollo, highlighted that the price-to-earnings (P/E) ratio for the S&P 493 (excluding Apple, Alphabet, Microsoft, Amazon, Meta, Tesla, and Nvidia) has maintained around 19 throughout the year.

However, for this smaller cohort of stocks, their combined P/E ratio has surged over 50%, from 29 to 45. This implies that investors are becoming notably enthusiastic about the prospects of a few companies, while the majority receive less attention.

Sløk pointed out the peculiarity of this overvaluation in tech stocks happening simultaneously with a substantial increase in long-term interest rates. Tech companies’ cash flows extend far into the future, making them more sensitive to discount rate hikes. Hence, Sløk finds the rally led by tech companies “inconsistent” with the concurrent surge in yields, raising questions about sustainability.

In conclusion, something must eventually give way, as Sløk suggests. Either stock values must adjust to align with prevailing interest rates or long-term interest rates must adapt to match stock prices. The uncertainty surrounding inflation may impact stock prices and risk-taking in various ways, offering potential benefits or challenges depending on the evolving outlook.

For investors, the longer the ascent of yields persists, the higher the risk of the Federal Reserve misjudging its policies by either tightening too little or too much, potentially causing unintended consequences. What exactly might break as a result remains a matter for hindsight.

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