Historically low rates and central bank stimulus have been a defining characteristic of the recovery. No other economic factors have driven more of the four-fold surge in the S&P 500 from its 2009 low.

That could be about to change.

The 10-year Treasury yield, now at 2.42%, is often compared to the average dividend yields as a measure of stock market attractiveness. The reasoning goes that if the average dividend yield of a stock is higher, investors can get a reasonably solid cash return versus bonds even if share prices are more volatile.

A 10-year yield higher than the average dividend yield is thought to be a warning sign for stocks because investors might be persuaded to take less risk and earn the higher yield in Treasuries.

#-ad_banner-#That idea hasn’t held up very well with the 10-year yield above 2% since November 2016, but the rising yield on another maturity may prove the theory.

The yield on the 2-year note recently surpassed the dividend yield, 1.89% versus 1.86% for stocks, the first time it’s happened in a decade. 

That could be a much bigger problem for stocks, especially for two sectors of the market.

Why Yield Investors Might Head For The Market’s Exit
The rise in the 2-year note above dividend yields is more meaningful because the shorter-term note is less susceptible to rate risk. Prices on the 2-year note don’t fall as much as rates increase compared to the 10-year. 

That makes them a much more attractive investment for yield-hungry investors in an increasing-rate environment.

As rates crashed to historic lows after the recession, many investors were forced to take more risk. This included pension funds, insurance companies and many others with the need for extremely safe investments but also a consistent yield to meet obligations. These investors pushed more of their portfolios into dividend-paying sectors in stocks.

As bond rates rise and become more attractive, many of these yielding stock sectors may lose that investor demand.

The Fed has signaled the potential for three rate hikes in 2018 from the current target of 1.25% to 1.50% for the benchmark rate. The market, according to the CME FedWatch Tool, is pricing in a 38% chance of an increase of 0.75% or more in the benchmark and a 36% chance of a 0.50% increase in rates.

Even if the long-end of the yield curve, the 10- and 30-year notes, continues to be held lower by tepid inflationary pressure, the short-end of the curve will almost certainly be pushed higher by rate hikes. An economic boost from the newly-passed tax cuts or global growth could surprise the market with higher rates than expected.

Changes In Yields Could Signal A Shift In Favored Stock Sectors
There’s little reason to think that stocks won’t do well this year. From the global economy to the new tax cuts, there are enough tailwinds to drive earnings growth. The rise in yields, at both ends of the curve, could limit gains in some sectors while boosting others.

The table shows the correlation of returns on each sector with the yield on the 10-year Treasury over four periods. A low or negative correlation shows that returns for the sector tend to rise when bond rates fall. A positive correlation shows that returns for the sector tend to rise when bond rates rise.

High-yield and traditionally-safe sectors like Utilities, represented by the Utilities Select Sector SPDR (NYSE: XLU), and Consumer Staples, represented by the Consumer Staples Select Sector SPDR (NYSE: XLP), show this relationship with yields.

Utilities are even negatively correlated with bond yields meaning the price of the Utilities ETF goes down as bond yields increase. 

The correlation between the two funds and bond yields has shown a closer relationship over the last five years compared to the longer periods. This seems to confirm the idea that yield-hungry investors have used the sectors as substitutes when falling yields pushed them out of bonds.

The two sectors with the highest correlation with bond yields, where prices rise along with bond yields, are financials and industrials. This makes sense for both. Financials benefit from rising yields because interest income is tied to higher rates, as long as the spread between short-term and long-term rates is positive. Industrials are highly economically-sensitive and rates tend to rise during good economic times.

The consumer discretionary sector, represented by the Consumer Discretionary Select Sector SPDR (NYSE: XLY), is also positively correlated with rates and companies in the space are set to benefit from the tax cuts because of higher average effective tax rates and higher consumer disposable income.

As the Fed pushes rates higher through 2018, whether long-term rates increase or not, investors may find more attractive yield in safer bonds versus dividend-paying stocks. Sectors outside of Utilities and Consumer Staples all show similar correlations with bond rates and could do relatively well on stronger economic growth.
 
Risks To Consider: The relationship between sectors and bond yields doesn’t happen in a vacuum. Other factors may cause sectors to rise or fall regardless of what happens to interest rates.

Action To Take: Consider reducing positions in yield-sensitive sectors like utilities and consumer staples while increasing positions in sectors with rate- and tax-related tailwinds over the next year.

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