Bond yields have been on a mini-surge this week. The current yield on the 10-year Treasury suggests it can rise even more in the short-term, making cyclical stocks look like good bets.
The 10-year yield rose to 1.46% on Friday from a low point of 1.3% this week. It passed 1.38% this week, a key level of support at which buyers had tended to step in for the past few months. Bond prices and yields move inversely.
Signs point to a continued climb for the 10-year yield. Bay Crest Partners’ chief market technician, Jonathan Krinsky, writes that the 10-year yield looks to be headed to 1.6%. With the yield pushing above 1.38% and breaking out of its six-month downtrend, he writes, it looks like “a new trading range is underway.”
This dynamic bodes well for cyclical stocks—ones that are more sensitive to changes in the economy. That’s because higher yields indicate the market expects higher inflation amid strong economic demand.
Of course, many central banks around the globe have signaled confidence in the economy as well. The Federal Reserve has suggested that the reduction of its bond buying program—a pillar of economic support since the pandemic began—could come as soon as November. Market-based inflation expectations for the next 10 years currently stand at 2.34%, according to St. Louis Fed data, another reason the 10-year Treasury yield likely could edge up further.
Small-cap companies can especially benefit in this environment. Those firms’ earnings typically rely much more heavily on growth in the domestic economy, and they have better access to capital when the economy is growing. And regardless of size, companies in economically-sensitive sectors—such as banking and oil—can benefit, too.
Since the 10-year yield began surging this week, the Russell 2000 index of small-cap stocks has risen 3%, outpacing the S&P 500’s 2.2% gain. Cyclical sectors on the S&P 500 have also beaten the broader index. The SPDR S&P Bank Exchange-Traded Fund (ticker: KBE) and the Energy Select Sector SPDR Fund (XLE), for example, have risen 5.6% and 7.7%, respectively in the same time frame.
However, too fast a rise in bond yields could dent all stocks, though the most economically-sensitive ones could still outperform. If bond yields suddenly spike to nosebleed levels, stock valuations could fall hard, as higher, long-dated bond yields make future profits less valuable. “The other variable to the answer is the speed with which rates rise,” says Hank Smith, head of investment strategy at Haverford Trust. “If that 10 year hits 2% by year-end, either the economy better be booming like it was in the second quarter or the equity markets are not going to take that very well.”
Whatever happens to the broader market, hiding out in cyclicals might make sense—so long as the economy keeps humming along.
Write to Jacob Sonenshine at jacob.sonenshine@barrons.com