The 10-Year Treasury Has A 5% Ceiling – 'Go Long SOXX', Analyst Says

The bond market has spent weeks behaving like the biggest threat to stocks. Now, the policy response could be creating the next leg higher for equities.

The U.S. Treasury doubled the size of its long-dated bond buybacks on Aug. 19, and for a few hours it worked.

By Friday, the 30-year Treasury bond yield had erased the entire decline and settled at 5.24%, back within a few basis points of the 19-year high it hit earlier that week.

Most of Wall Street read that round trip as a failure.

Chen Zhao, chief global strategist at Alpine Macro, reads it as beside the point.

In a report published Monday, Zhao said long bond yields may have already reached their peak, or may soon reach it, because the government has now made clear it intends to defend the bond market.

The ceiling is what matters for equities not whether any single operation moved the needle.

“We should not underestimate the Trump administration’s resolve to defend the bond market,” Zhao said.

Bond Yields May Have Hit A Peak

Start with the level that triggered the intervention.

The 10-year Treasury note yield reached 4.74% before the Treasury stepped in.

Zhao said that is not an excessive number when set against nominal gross domestic product — the total value of everything the U.S. economy produces, before stripping out inflation — which is growing at 6.5% a year.

Yields running below the economy’s growth rate are historically unremarkable.

His hunch, he said, is that there is a good chance the 10-year does not exceed 5%.

Why This Is Bullish For Stocks

The mechanism that carries this into the stock market runs through valuation. When yields climb, investors demand more compensation from equities, and the price they will pay for each dollar of expected future profit falls.

That ratio — the forward price-to-earnings multiple — has dropped roughly 14% from its recent high on the S&P 500, even while the index itself pushed to records.

Share prices went up. What investors were willing to pay for the earnings behind them went down.

“The recent spikes in long bond yields have sharply depressed earnings multiples, even though share prices have soared”

The bond-buying program, Zhao said, “is unambiguously positive for stocks.”

Should the buybacks produce a lasting reduction in the long end of the curve, he said, those compressed multiples would have room to expand again.

“Should the bond-buying program produce an enduring impact in lowering the long end of the curve, it would be very bullish for stocks as lower bond yields would allow multiples to expand,” Zhao added.

3 Conclusions For Investors

According to Alpine Macro there are three key implications:

1. First, the risk-reward in bonds may be improving. With Washington increasingly willing to defend the Treasury market, Alpine Macro said long-term yields could be at or near a peak, with a good chance the 10-year note does not push beyond 5% — enough to justify modestly extending exposure to longer-dated Treasuries.
   
2. Second, the dollar looks set to weaken, though the firm does not expect a disorderly slide, which makes selective positions in higher-yielding currencies such as the South African rand and the Brazilian real more attractive.
   
3. Third, the equity rally may be broadening beyond the megacaps. Alpine expects the next phase of the artificial intelligence trade to spread across the wider market, leaving the equal-weighted index – tracked by the Invesco Equal-Weight S&P 500 ETF (NYSE:RSP) – undervalued at 18 times expected earnings and semiconductor shares – tracked by the iShares Semiconductor ETF (NASDAQ:SOXX) – oversold.

“We believe semi stocks are oversold and undervalued. Go long SOXX.”

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