Why will surging US Treasury yields suppress stock market?

Hawkish comments from Federal Reserve Chairman Jerome Powell pushed the US Treasury yield to its worst inversion since 1981 on Tuesday, renewing concerns about what many investors see as a long-awaited recession signal. US equity markets closed lower, with $S&P 500(.SPX)$ down -1.53%. $NASDAQ(.IXIC)$ $DJIA(.DJI)$

1. Why will US stocks fall as US Treasury yields grow?

•  Does the rise of Treasury yields necessarily mean the decline of US stocks?

The answer is not necessarily yes, but in mose cases they are negatively related according to our analysis.

 Risk appetite -US Treasury yields increase and the valuation of risky assets decreases

When the return on US Treasury is higher, then money flows into US Treasury. For other assets, the capital flows out and prices fall.

The 10Y US Treasury yield acts like the denominator r indicator of the DCF valuation model, an important valuation model in the equity market.

10-year Treasuries reflect investors' aversion to risk appetite and future return requirements. All risky assets are priced with the 10-year US bond yield as the denominator. When the denominator keeps rising and cash flows remain unchanged, the prices of other risky assets will fall.

In addition rate hikes will cause the US Treasury yield to rise. So if inflation expectations heat up, it will also make US Treasury yields rise.

But last week, the 10-year US Treasury yield rose above 4% at one point, but risky assets such as stocks are still rising. This is a difficult question for Wall Street to answer.

2. Why is the inversion of the 2Y and 10Y Treasury yields important?

 Investors see part of the yield inversion as a recession indicator, mainly the spread between the 3-month and 10-year US Treasuries and the spread between the 2-year and 10-year.

Since last July, the 2Y US Treasury yield has been higher than the 10Y US Treasury, presenting an inversion.

As short-term Treasury yields soared, the degree of inversion reached 103.1 basis points on Tuesday, the largest difference between short-term Treasury yields and long-term Treasury yields since September 1981.

At the time, the US economy was in the early months of a recession that would last until November 1982, making it the worst recession since the Great Depression.

Brian Jacobsen, senior investment strategist at Allspring Global Investments, said:

It's not unusual to see an inversion in the yield curve, but it's unusual to see an inversion of this magnitude. We haven't seen anything like this in a long time.

Typically, there are three different scenarios for an inverted yield curve.

1) Central banks tighten too much and pivot slowly; recession ensues (positive for government bonds, negative for stocks/credit).

2) To avoid a recession, monetary policymakers remove stimulus before pivot (positive for equities and fixed income assets).

3) The US economy proves it can handle a significant rise in interest rates without a significant deterioration (positive for equities, negative for fixed income).

Analysts sugget investors stay cautious when investing  in short-term bonds

As US Treasury yields across maturities reach multi-year highs, money is flowing from equity-focused ETFs into fixed income funds. With yields topping 5%, short-term US bonds are attracting investors with returns outpacing those generated from S&P 500 components to traditional 60/40 stock and bond portfolios.

Analysts in the mainstream of the market believe that short-term US Treasury yields will not stay at these higher levels forever and could eventually go lower.

The view that yields may be peaking has also led some analysts to caution investors to exercise extra caution when investing in bonds.