Stock-market investors face reality of 5% Treasury yields. Here’s what’s next.

Bond market volatility is also elevated compared to historical levels. The ICE BofA MOVE index, known as the “fear gauge” of the bond market, reached 142 in early October, its highest level since May. On Friday it was around 135.5, according to FactSet data.

“I think we are in a new era where having bonds is not safe. Bonds are not risk-free: the 30-year Treasury lost more than the Nasdaq in 2022,” said Nancy Davis, portfolio manager of the Quadratic Interest Rate Volatility & Inflation Hedge ETF.
IVOL.

Rising Treasury yields have been the biggest contributor to the recent stock market weakness, according to Jay Hatfield, CEO of Infrastructure Capital Management.

US stocks ended the week lower, with the Dow Jones Industrial Average
DJIA
fell 1.6%, and the S&P 500
SPX
2.4% less. The Nasdaq Composite
COMP
It lost 3.2% over the past week, according to Dow Jones market data.

Stocks are essentially very long-duration securities, which makes them sensitive to interest rates, Hatfield said. As interest rates rise, future stock earnings are discounted at a higher rate.

Rising Treasury yields are also making risky investments less attractive. Fixed-income yields are outpacing the earnings performance of S&P 500 companies by an increasingly wide margin. "It simply doesn't make sense to own stocks at high prices with a 10-year Treasury yield close to 5%," according to José Torres, senior economist at Interactive Brokers.

Hatfield said his models show that an increase of every 40 basis points in the 10-year Treasury yield theoretically reduces the S&P 500 multiple by one point.

Over the past three months, the 10-year Treasury yield has risen 108 basis points, implying the S&P 500 multiple should fall nearly three points., Hatfield pointed out. The S&P 500 price/earnings ratio stood at 19.34 on Thursday, according to Dow Jones market data.

Sentiment was also not helped by Federal Reserve Chair Jerome Powell on Thursday, who described bond market volatility as something the Fed should let "play out," though he said rising bond yields Treasury bonds are tightening financial conditions and could potentially substitute higher Fed interest rate hikes “on the margin.”

Read: Bond traders see 'green light' to boost yields after Powell comments: Fed watcher

From a technical perspective, Torres said he expects the 10-year Treasury yield to reach 5.29% in the coming months. If it exceeds that, “we are in virtually uncharted territory in terms of how far we could go.” The yield could be as high as 6% this cycle, until a recession brings it down. Torres said.

Hatfield is more optimistic and expects the 10-year Treasury yield to peak around 5%. Next week, “if rates are even somewhat stable, the stock market should be driven more by earnings than interest rates, because we are getting the profits from the tech megagiants and there is no way people can ignore them Hatfield said.

Microsoft Corp.
MSFT,
-1.40%,
Google's parent company, Alphabet Inc.
GOOGLE,
-1.56%

and Visa Inc.
V,
-0.18%

They will report their earnings results for the third quarter next Tuesday. Meta Platforms Inc., parent of Facebook.
GOAL,
-1.33%

and amazon
AMZN,
-2.52%

They must report next Wednesday and Thursday, respectively.

Still, Hatfield said he wouldn't make any big moves in the current market environment. “We are optimistic about rates and the stock market, but things are uncertain. There is still a war in the Middle East. And positive inflation data will not arrive until November,” he added.

Preferred stocks, which pay a fixed dividend to shareholders, could be a good option, and investors could choose to add some technology stocks to their earnings reports next week.

All that said, Hatfield said his biggest advice to investors is to remain cautious. “This is swimming for adults. “This is a market where you want the best traders in the world to deal with it.”

With bond yields at high levels, it is best for active management rather than passive investing, Torres said.

“We will have much more moderate stock market performance in the next five to ten years, with rates this high. “I think it's really an environment of stock picking and choosing the right companies and sectors that are destined to thrive at the right time,” Torres said.

The next important data are the preliminary manufacturing purchasing managers' indexes for October, which will be released on Tuesday, and the personal consumption expenditure (PCE) price index for September, which will be released on Friday of next week.

Investors will await September new home sales figures on Wednesday and data on US third-quarter GDP, weekly initial jobless claims and September durable goods orders on Thursday.