You’d think Armageddon was near.
“All hell might break lose,” a Wall Street veteran told CNBC recently. A Bloomberg headline warned, “Market euphoria may turn to despair.”
What doomsday scenario do both these omens describe? They depict investor fears of what might happen in the financial markets if the 10-year Treasury yield suddenly crosses the 3 percent mark this year — a level it hasn’t breached since January 2014, and before that, 2011.
Over the last three months, the 10-year yield has gradually marched higher, only to hover just below that level. It started this week around 2.87. Why all the jitters about this one number, though?
[See: 7 ETFs to Buy as Interest Rates Rise.]
First, some background. The 10-year Treasury rate is an important benchmark in the U.S. economy, guiding other interest rates on things like your mortgage, auto loan, credit cards and business loans. It’s been rising in part because the Federal Reserve has removed some of its crisis-era stimulus in response to a stronger labor market and healthier economy. Over the last couple years, stocks have largely risen in tandem, mainly because in this case, rising interest rates reflect good news: The economic picture is improving.
But beware, eventually there’s a tipping point. There’s a threshold where rising interest rates are no longer thought to be beneficial.
Take, for example, if you’re a homebuyer. Once mortgage rates pass a certain point, it’s harder for you to afford a home, so maybe you won’t bother touring open houses anymore.
If you’re a business owner, there’s some point where taking out a loan becomes too expensive, and you won’t be able to borrow money to launch a new project or build a new factory.
Meanwhile, for Uncle Sam, higher interest rates mean the government is borrowing funds at higher costs. The expenses associated with servicing the government’s debt will rise and could crowd out spending on other programs in the federal budget.
Finally, there’s also some tipping point where stocks lose their luster. Higher interest rates eat into stock valuations. Plus, long-term investors may decide to buy more bonds, in lieu of stocks, because they offer steady income with fewer risks.
[See: 11 Steps to Make a Million With Your 401(k).]
“Stocks haven’t had much competition lately as interest rates for competing investments have been zero to 2 percent,” says James Miller, president of Woodward Financial Advisors in Chapel Hill, North Carolina. “But if interest rates go up and bonds are suddenly starting to yield 3 percent to 4 percent … investors start to think, ‘Am I willing to experience all this extra volatility for what is now only a few percentage point better outcome?'”
Wall Street analysts wrack their brains (and their financial models) trying to estimate the important tipping point. Could it be 3 percent?
Some headlines might have you think so, but the truth is, there’s no magical line in the sand.
“I think those fears are greatly exaggerated and the differential between 2.9 percent and 3 percent, I can’t imagine causing a market crash,” says Jerry Paul, senior vice president and fixed income portfolio manager at ICON Advisers in Denver.
Whatever the number is — 3 percent or otherwise — it’s probably not a cliff the market suddenly falls off of, but rather just a point on a continuum, says Jonathan Golub, an equity strategist with Credit Suisse.
Golub estimates the real number to watch is more like 3.5 percent, but he stresses one thing: The day the 10-year Treasury gets to that point need not be a chaotic one for financial markets. Rather, that’s a neutral point. In fact, by his calculations, stocks will be least sensitive to rates when the 10-year hits 3.5 percent. The more rates advance beyond that point, the more headwinds they’ll pose to stocks. But again, there’s no cliff — the effect is far more gradual than that, he says.
“The data is not saying that when we get to 3.5 percent, there’s an explosion,” Golub says. “That’s the point where interest rates go from neutral, to beginning to become more negative. It doesn’t mean stocks can’t do well. It’s simply that interest rates become a bigger headwind to success, but that doesn’t mean that they cause failure.”
If stocks do sell off significantly when the 10-year Treasury eventually hits 3 percent or 3.5 percent, Golub says it’s probably not because of fundamentals, but rather because of human misunderstanding.
[See: 7 of the Best Stocks to Buy for 2018.]
“If the market sells off out of fear once we go beyond a 3 or 3.5 number, that should prove to be a wonderful buying opportunity,” he says. “The best time to invest is when the market worries about things that don’t come true.”
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Why Investors Shouldn’t Panic About 3 Percent Treasury Bonds originally appeared on usnews.com
