Why 5% bond yields could wreak havoc on the market

The yield on the 30-year Treasury bond rose above 5% again on Friday, opening the door to the likelihood of a more sustainable rise above that mark and the risk that the benchmark 10-year yield also follows — moves which could wreak havoc across financial markets.

One big reason is that investors are likely to demand greater compensation for taking risk as yields keep climbing further into 16-year highs, asset managers said. Corporate credit spreads could keep widening in a sign of worsening economic conditions and higher overall risk. And with returns on government debt becoming a more favorable option for investments, the stock market may be vulnerable to repeated drubbings.

Read: Treasury yields are climbing: ‘There’s never really been such an attractive opportunity for fixed-income investments’

Stock investors nonetheless shook off Friday’s stunning official jobs report for September, which saw the U.S. add almost twice as many jobs as forecasters had expected.

All three major stock indexes


were higher in the New York afternoon even as yields climbed on everything from the 1-month T-bill
to the 30-year bond
The yield on the long bond traded at 4.9% after rising past 5% during the morning and the rate on the 10-year note
was up at almost 4.8%, some of the highest levels since the second half of 2007.

Yields are returning to more normal-looking levels that prevailed before the 2007-2009 recession as the result of aggressive selloffs in government debt. More important than the absolute level of yields is the speed with which they have been heading to 5%. In the words of analyst Ajay Rajadhyaksha of Barclays earlier this week, there’s “no magic level” that will turn the current selloffs into a rally, and stocks have substantial room to reprice lower before bonds stabilize.

See also: Stock market likely to correct if 10-year Treasury yield reaches 5%, RBC says

“I think the market isn’t breaking yet, but a 5% 10-year yield is coming,” said Robert Daly, who manages about $4.5 billion in assets as director of fixed income at Glenmede Investment Management in Philadelphia. “We’re already here on 30s and not that far away on 10s. Investors are trying to figure what level breaks the market, and I don’t think you can put your finger on the pulse as to what that level is.”

Still, “a higher level of interest rates and yields is going to start having ramifications for broader markets at large,” leaving many investors hesitant to buy just about anything due to the volatility, Daly said via phone on Friday, after the release of September’s hot payrolls data.

Friday’s data, which showed the U.S. creating 336,000 new jobs last month or almost double what economists had expected, is opening the door to a possible interest rate hike by the Federal Reserve on Nov. 1. The strong labor market means the Fed’s higher-for-longer mantra in rates is still in play and “the market is in a tenuous position to navigate all these things because of all the uncertainty,” Daly said.

“Yields sustainably above 5% for a longer period of time will act as a weight on the market in terms of how you value risk compensation,” he said. “Investors are going to ask for more compensation to take risk and when you see liquidity evaporate more and more, that’s what’s going to turn the market over.”

Friday’s price action was the second time this week that data related to the robust U.S. labor market has triggered a bonds selloff. On Tuesday, a snapback in U.S. job openings for August sent the 10- and 30-year yields to their highest closing levels since August-September of 2007.

The next day, high-grade corporate-credit spreads widened for a seventh consecutive session. Daniel Krieter, a fixed-income strategist at BMO Capital Markets, wrote that “if rates continue to move higher or simply remain at these elevated levels for a significant period of time, it is going to have a pronounced effect on the creditworthiness of corporate borrowers, particularly in the high yield space.”

“It’s not difficult to envision 10s maintain a range between 4.75% and 5.00%,” Krieter’s colleagues, Ian Lyngen and Ben Jeffery, wrote in a note on Friday. “The longer 10s hold this range, the more convinced the market will become that elevated yields are here to stay. Admittedly, we’ve been surprised by the muted response in U.S. equities from the spike in yields and expect that’s due in part to the expectation for a swift reversal. In the event a correction fails to materialize, stocks will be overdue for a more meaningful reckoning.”

The risk of “something breaking” will remain top of mind and “there is no shortage of risks facing equities and credit as rates continue to climb,” Lyngen and Jeffery said. “It’s not only the outright level of yields, but the length of time that borrowing costs stay elevated will also hold implications for risk asset valuations.”

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