It's been rough patch for stocks with the Dow and the S&P 500 at risk of posting their first monthly loss in a year as investors fret about accelerating inflation and a spike in bond yields. But most Wall Street strategists believe that fears about inflation may be overblown and it will be a while before the 10-year Treasury yield hits 3%--a level that has historically tended to herald a brewing bear market.
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"We are in a tricky time with inflation. One would think we will see a couple more months of elevation, then flatten from there," said Kevin Giddis, head of fixed-income capital markets at Raymond James.
The Federal Reserve earlier this week indicated that it isn't too concerned with inflationary pressure as of yet. Minutes from the Fed's January meeting showed that officials believe the economy is stronger than it was at the end of 2017 and although they expect inflation to pick up, only two members were worried about the possibility of the economy overheating.
The consumer-price index climbed 0.5% in January, its biggest increase in five months as the cost of rent, clothes, gasoline, health care and auto insurance all rose.
But as Michael Arone, chief investment strategist for State Street Global Advisors' U.S. SPDR business, illustrates in the chart below, two main inflation gauges--the core CPI or the personal-consumption expenditure deflator, the Fed's preferred measure of inflation--remain below average.
Still, the 10-year yield crept up to a four-year high of 2.956% this week as inflation jitters lingered. Even so, strategists believe it will take a lot more triggers for the 10-year yield to hit 3%--a line in the sand that some believe would create a near-term tension between the safety of bonds and riskier stocks.
"Each data point matters. We will need to see more negative inflationary news to see 3%. Especially since the 2.95% area held so well. It may be longer than people think before we see 3%," said Giddis.
Among the events to watch for in the coming week that could shed further light on the economy and by extension inflation are Fed Chairman Jerome Powell's testimonies at the House and the Senate on Tuesday and Thursday, gross domestic product data for the fourth quarter on Wednesday, and consumer spending and core inflation for January on Thursday.
Traditionally, 3% is viewed as a critical level for stocks where they become increasingly less attractive.
"The best S&P 500 returns have occurred when the 10-year Treasury yields has ranged from 2% to 3%, particularly when yields have been rising. While average historical stock returns remain positive until interest rates cross above 6%, the probability of losing money begins to increase as interest rates cross above 3%," Savita Subramanian, equity and quant strategist at Bank of America Merrill Lynch, said in a report.
However, Tom Lee, a managing partner at Fundstrat Global Advisors, emphasized that although investors fear yields rising above 3%, given numerous crashes associated with that particular level, the more critical number to watch is 4%.
"Markets worry about 3%..., but history shows 4% [is] the key level" as that is where price to earnings ratio starts to feel pressure, he said.
The last time interest rates were this low was the 1940s-1950s and the P/E ratio, a popular measure of equity valuations, and the 10-year moved in tandem. But as the chart below demonstrates, when interest rates climbed above 4%, P/E ratios started to contract.
For the time being, Lee played down market fears over rates, noting that the Fed needs to tighten more than 1.28 percentage points to impact real interest rates. He also said that this time, higher rates could lead to higher stock prices as they did during the 1950s and the 1960s as long as the 10-year yield remained under 4%.
The S&P 500 rose 43.34 points, or 1.6%, to close at 2,747.30 while the The Dow Jones Industrial Average climbed 347.51 points, or 1.4%, to 25,309.99. The Nasdaq Composite Index added 127.30 points, or 1.8%, to 7,337.39. All three benchmarks logged their second straight week of gains.