The bond market has Wall Street on high alert — it could catalyze the first official stock market correction since the March 2020 lows.
If the yield on the 10-year Treasury Note (^TNX) climbs to 2.0% from the current 1.62%, that could be enough to tip the risk market scales and lead to a 10% correction in the S&P 500 (^GSPC), the benchmark for U.S. stocks. And if the 10-year climbs to 2.5%, bonds may start becoming more attractive instead of stocks, according to the latest BofA fund manager survey, which tracks the opinions of global portfolio managers in charge of $630 trillion in assets.
"Higher growth and higher inflation is now the consensus," writes BofA, noting that 93% of respondents expect higher inflation over the next year and 49% of those surveyed expect higher short-term rates — the biggest jump in two years. (Importantly, they still don't expect the Federal Reserve to start hiking rates until February 2023.)
Longer-term bond yields have been soaring this year, as the vaccine rollout has powered the reflation and reopening trades. The yield curve is also expanding, reflecting increased growth prospects that benefit banks, as they can borrow at low rates and lend at higher rates.
Consensus is now that cyclical sectors will outperform — a 180 from last year, says BofA.
This rotation has benefitted the value and cyclical sectors, like industrials (XLI), energy (XLE) and financial (XLF) stocks — which have all outperformed this year. Meanwhile, defensive sectors, like consumer staples (XLP), health care (XLV) and utilities (XLU) have been the worst performers.
Tech (XLK) is the fourth biggest sector laggard this year, as attention (and money) has shifted from the high-growth names like Peloton (PTON) and Zoom (ZM) to the less sexy names that are more likely to benefit from a recovery, like Caterpillar (CAT), American Airlines (AAL) and Goldman Sachs (GS).
A record 52% of those surveyed by BofA now think we'll see more of the same over the next year — that value will outperform growth. And while it would be reasonable to expect all these trends to continue if bond yields simply climb higher, problems emerge for the entire market when the moves in the bonds are too rapid or disorderly. The pace of the rise or fall in yields matters.
Bond vigilantes perk up
On Feb. 25, a 7-year Treasury auction sent bond prices plummeting and their yields surging higher. That day, the 10-year yield spiked up as much as 22.5 bps — the biggest jump since the prior March. Meanwhile, the Dow was down 1.75%, and the Nasdaq Composite (^IXIC) was down 3.5% — its worst one-day performance since September.
When the bond vigilantes smell blood, the carnage tends to spill into the equities markets. In the end, the Nasdaq suffered a 10.5% drawdown, but the benchmark S&P 500 was only down 4.2%.
"Nobody believed that rates at 1.5% would cause an equity correction. But the move from 1.5% to 2% is critical as 43% of investors now think 2% is the level of reckoning in the 10-year Treasury that will cause a 10% correction in stocks," says BofA. If it pops to 2.25%, another 17 percentage points — a total of 60% of those surveyed — expect a correction.
In this scenario, BofA advises two contrarian plays: long cash while short commodities, and long utilities while short industrials. Industrials and commodities have been on a tear this year (with many analysts touting a new commodities supercycle. They could theoretically get hit the hardest as good bets are closed to pay off the bad ones and investors reassess the risk horizon.
Utilities (XLU), which are interest rate proxies thanks to their fat dividends, tend to outperform when interest rates go higher. So it makes sense that aside from bets on king cash, utilities should outperform while commodities and industrials should be shunned or outright shorted.
The BofA data also provide a glimmer of hope for the floundering growth and tech trade. "'Long tech' is still deemed the most crowded trade by 34% of the respondents, but is down significantly from 80% last [September]," says BofA. This indicates lower sentiment in a sector that's experiencing the biggest drop in exposure in 15 years.
Separately, expectations for a higher yield curve, while elevated, are down from a peak of 66%. Even if the 10-year climbs to 2%, if short-term rates rise faster, the curve could actually flatten, which is bullish for growth stocks.
Bottom line: The flows out of growth and into cyclicals may be overdone, such that a quick spike to 2% in the 10-year is quickly reversed with a flattening yield curve. In this scenario, we could see a renewed multi-week rotation into the growth and tech trades.
Still bullish on stocks long-term
BofA respondents also no longer see COVID-19 as the biggest headwind to risk markets. That's a welcome change for the first time in a year. Instead, they're worried about inflation and a taper tantrum in the bond market, which would come as the Fed puts the breaks on the economy. Further, only 15% of those surveyed think we're in a bubble — meaning there's more potential gas for the risk rally.
When it comes to the economy writ-large, respondents still overwhelmingly expect it to leapfrog the low-to-medium growth that characterized the prior decade. A record 89% expect a V-shape boom for GDP, according to BofA.
Expectations for corporate profits are running high as well.
In fact, Wall Street has never had higher hopes for profits, eclipsing the prior highs of December 2009 and February 2002. Importantly, these highs in profit expectations occurred toward the beginning of long, sustained economic and market recoveries.
Finally, Wall Street also maintains a very bullish view for stocks this year. In a separate note, BofA projects the S&P 500 to reach 4065, which would reflect an additional 2.6% upside from Tuesday's close. The BofA Bull & Bear Index, a contrarian indicator for stocks that flipped bullish in August and remains in neutral, is also still saying it's not time to sell.
All of this is good news for stocks, but there could be stumbles along the way.
Jared Blikre is a correspondent focused on the markets or Yahoo Finance Live. Follow him @SPYJared