Strong earnings growth has cushioned the stock market from rising yields. But ever-rising bond rates may eventually take a toll.
S&P 500 earnings estimates have been rising, while the P/E ratio for the next 12 months has declined.
Treasury yields are rising, but stocks aren't falling.
That has investors trying to figure out how high the yield on the 10-year Treasury note needs to rise before the stock market finally cracks. But there probably isn't a magic number. What matters is whether rising rates begin to overwhelm the two forces that have protected stocks so far: earnings growth and low volatility in the bond market.
The earnings growth offset
The first point to note, which may be obvious, is that stocks aren't rising, either. The S&P 500 SPX is trading at about the same level it was on June 2, when the 10-year yield was at 4.45%. Meanwhile, the Nasdaq-100 index NDX is down about 5% from its June 2 closing high.
Things haven't been even worse because earnings estimates have been rising. As a result, the price-to-earnings ratio for the next 12 months has fallen to around 19.1, down from 21.3 on June 2. While the index has stalled, the P/E ratio has contracted by more than 9%. Earnings have grown 12.6% over that same period, from around $356 to $401. So higher earnings have offset the decline in the P/E ratio.
The opposite paths of the S&P 500's forward P/E (dark blue line) and its forward earnings per share.
It is easier to visualize the relationship between stocks and bonds using the S&P 500 earnings yield - the inverse of the P/E ratio - which has risen to 5.2% from around 4.7% since June 2. So while it may seem as if stock prices have been immune to the rise in Treasury rates, they haven't. In fact, stocks today are technically cheaper than they were prior to the recent move up in rates. It is just that earnings estimates have risen.
This is where things can get tricky for stocks. If at some point, the market begins to view higher rates as a drag on economic growth, potentially leading to lower earnings estimates, the S&P 500 could face a rather large decline. For example, if the S&P 500 traded at a 19.3 P/E ratio and earnings dropped back to $356, the index would trade around 6,870.
Alternatively, if the 10-year yield BX:TMUBMUSD10Y continued to rise to, say, 5.25%, and the S&P 500 earnings yield rose in tandem to maintain the current spread of roughly 25 basis points, the earnings yield could climb to around 5.5%, corresponding to a P/E ratio of roughly 18.2. If earnings growth simply stopped at current levels, that would put the S&P 500 at around 7,280.
Right now, though, if earnings continue to grow, the index may remain relatively immune to a large drawdown, although it may not have much room for upside, either.
How the 10-year Treasury yield (red line) compares to the S&P 500 NTM earnings yield (blue line) from late 2023 to late 2026.
Bond-market volatility has remained low
Another factor is that bond-market volatility has remained low, despite rising rates. One reason stock markets reacted negatively in 2022 as Treasury rates rose was that earnings estimates fell and bond-market volatility rose sharply. To date, bond-market volatility has remained subdued, as measured by the Bank of America MOVE Index, which measures the bond market's implied volatility.
Historically, the MOVE Index and the S&P 500 have an inverse correlation, which means when bond-market implied volatility rises, stocks tend to fall. Right now, the 60-day rolling correlation is around -0.29, suggesting a relatively weak relationship. However, when MOVE rises quickly and reaches higher levels, that relationship tends to strengthen and turn more negative, increasing the pressure on stocks.
The ICE BofA MOVE Index and the S&P 500, along with their 60-day correlation, from 2021 to 2026.
However, despite the move higher in Treasury yields, we have not seen a meaningful change in volatility, allowing stocks, for the most part, to shrug off the rise in rates. If that changes and implied volatility begins to rise, it could quickly shift the equation for the equity market and lead to a more pronounced stock selloff.
Two factors to watch
Right now, stocks have been cushioned from rising bond yields because earnings growth has offset the P/E multiple contraction caused by higher rates, while bond-market volatility has remained subdued. If those conditions persist, the market may avoid a major drawdown, although further upside could become increasingly difficult.
The real risk, then, isn't that the 10-year Treasury yield reaches some predetermined level. It's that rising rates eventually weaken earnings expectations while also pushing bond-market volatility higher. If those two cushions disappear at the same time, the adjustment that has so far taken place almost entirely through valuation could quickly shift into stock prices.
Michael Kramer is the founder of Mott Capital Management and a long-only investor focused on macroeconomic themes. He analyzes long-term macro trends and short-term market risk using technical analysis, fundamentals and options-market positioning. See here for further disclosures.
-Michael Kramer
Comments