Why 2-year Treasury yields are the ‘root problem’ for the struggling stock market, according to this Morgan Stanley portfolio manager

It will be tough for the US stock market to make much headway back from the bear market with two-year Treasury yields at or above 4%, according to Andrew Slimmon, equity portfolio manager at Morgan Stanley Investment Management.

“It’s hard to convince investors to take risk when the two-year risk-free rate is north of 4%,” Slimmon said in a phone interview. “I think that will continue to weigh on stocks until we see some reversal.”

The yield on the two-year Treasury note has risen in recent weeks as investors anticipate further interest rate hikes from the Federal Reserve as it aims to curb high inflation. The two-year yield rose to 4.315% on Monday – the highest since August 14, 2007 based on 3 pm Eastern time levels, according to Dow Jones Market Data. That compares to 0.73% at the end of last year.

The average 35% of the S&P 500 index typically has a higher dividend yield than the 2-year Treasury note, according to Slimmon. But that share is much smaller now at around 11%, he said.

By comparison, about 20% of the S&P 500 typically provides a dividend yield above the 10-year rate, not far off from the current percentage of about 18%, Slimmon said.

“I just see the stock market getting out of this bubble until you get some relief on the short end of the yield curve because it’s very competitive,” he said, referring to the broad S&P 500 index.

The S&P 500 carved a new 2022 low on Monday, closing at 3,655.04, and the blue-chip Dow Jones Industrial average fell into bear market territory, according to Dow Jones Market Data. So far this year, the S&P 500 is down 23.3% through Monday, while the Dow has fallen 19.5% over the same period, according to FactSet data.

Read: The Dow joins the S&P 500 in a bear market: What investors need to know

The tech-heavy Nasdaq Composite is struggling for deeper losses in 2022, plunging about 31% through Monday, FactSet data shows.

But valuation multiples for the S&P 500 index have been compounded by big tech companies, and investors are “hidden” in some mega-cap stocks, according to Slimmon. “There are a lot of companies that are way below the market,” with some “attractive” opportunities in individual stocks, he said.

One of the areas Slimmon said he likes is hitting home-related stocks after consumer sentiment weakened earlier this year based on a University of Michigan survey.

The US stock market was down in early afternoon trading on Tuesday, with the three major benchmarks struggling to bounce back after five straight days of losses. The Dow DJIA,
-0.43%
was trading 0.6% lower, while the S&P 500 SPX,
-0.21%
fell 0.5% and the Nasdaq COMP,
+0.25%
slipped 0.2%, according to FactSet data, at last check.

“I think the fundamental problem for the stock market right now is that the two-year Treasury is a very competitive alternative to stocks,” Slimmon said.

The yield on the two-year Treasury note TMUBMUSD02Y,
4.291%
It was down about two basis points Tuesday afternoon at 4.29%, FactSet data shows, at last check. 10-year Treasury yield TMUBMUSD10Y,
3.978%
Meanwhile, it was up 10 basis points at about 3.97%, after rising to its highest level since April 2010 on Monday based on 3 pm Eastern time levels tracked by Dow Jones Market Data.

Both yields could decline as the economy slows, and there could be a recession, as a result of the Fed tightening its monetary policy, or as inflationary pressures show signs of easing, said Slimmon.

Also read: Rising US dollar is creating ‘unfundable situation’ for stock market, says Morgan Stanley’s Wilson

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