(Bloomberg) -- Stock traders knew it was an ugly setup entering Monday, with futures lower in premarket action and Treasury yields racing higher after Moody’s downgraded the US debt at the very end of last week.
But then a weird thing happened as trading got underway: The bond market calmed down. The yield on 10-year Treasuries, which had leaped the highest since February, began to fall, eventually dropping below where it started the session. That gave small investors in the stock market the all-clear sign to buy the dip, dragging the S&P 500 Index most of the way out of a decline that had reached more than 1% to finish up 0.1%.
And with that, the lightning-quick $8.5 trillion rally in US stocks kept running for another day.
“At the moment, the fear of missing the bounce and follow-through is stronger than the prospect of anything going wrong with US’s credit rating from late-to-the-table Moody’s,” said Mark Malek, chief investment officer at Siebert. “That does not mean that there is no ‘real’ risk associated with the downgrade, if something goes wrong with trade negotiations, all bets are off.”
The S&P 500 fell 0.3% by 9:39 a.m. in New York on Tuesday, as traders awaited fresh catalysts after a six-day winning streak.
Stocks, which are riskier than bonds, are highly sensitive to credit-rating downgrades. When investors get worried about a government’s ability to pay its debts, they pull money out of equities and pile into safer assets, which usually means US Treasuries. Many professional investors have sold their equity holdings, leaving the market to the retail crowd.
“There was not a lot of news in the downgrade, and then the bigger dynamic is that many investors are sitting on sidelines so any pullback is leading to dip buying,” said Tom Lee, founder of Fundstrat Capital.
Fed Model
A variety of impulses were behind Monday’s stock market rebound. House Republicans moved a tax-cut bill that’s expected to stimulate growth out of committee, bringing it closer to passage in that chamber. A barometer of the cost of US equities versus Treasuries, known as the Fed Model, is signaling that yields can move higher before the damage spills over into the stock market. However, some Wall Street pros question the significance of the measurement.
“The model has been showing that the S&P 500 is undervalued since 2005 no matter what,” said Ed Yardeni of Yardeni Research, who coined the term Fed Model. “So it kept you in the stock market for sure.”
And then there’s Morgan Stanley’s Mike Wilson, who’s urging investors to step into any dips in stocks as the odds of a recession have fallen based on the trade truce between the US and China. That sentiment was echoed by strategists at HSBC, who see the US-China trade deal was a game-changer for stocks, adding that sentiment and positioning are sending the “strongest buy signal in earnest since 2022.”
Moody’s Ratings downgraded US Treasuries to Aa1 from Aaa after the market close on Friday, citing a deepening concern that ballooning federal debt and deficits will damage America’s standing as the preeminent destination for global capital and increase the government’s borrowing costs.
“The stock market is immune in the same way that one gets immunity from having survived an illness,” Malek said. “The market has survived such extremes in the past five years, what we now consider a common cold would have been a plague ten years ago.”
Bond yields jumped early Monday, and as of 9 a.m. the 10-year and 30-year had both climbed nine basis points to 4.56% and 5.04%, respectively. But they quickly simmered and kept falling. By the time stocks stopped trading, the 10-year yield was down three basis points to 4.45%, and the 30-year had fallen four basis points to 4.9%.
Market’s Message
“The downgrade seemed out of touch with the market’s message,” said Chris Verrone, head of technical and macro strategy at Strategas Securities. “What the move in rates is not hitting, at least so far, is cyclicality. We’d be more uncomfortable with yields if this was not the case.”
Indeed, strength in cyclical sectors that has been sending a bullish signal for stocks, continued Monday with industrials and consumer staples in the green.
The earnings yield on S&P 500 has been sitting below what’s offered by 10-year Treasuries since early 2024, a development that before last year was seen in the aftermath of the dot-com bubble. As a general rule, the higher the gap between the payout that stocks offer next to bonds, the better, as investors get compensated for the risk associated with investing in stocks.
But the valuation argument is just one factor among many, and abandoning stocks just for that reason would have meant missing out on a 23% rally last year. This is why so many Wall Street pros say the Moody’s action doesn’t spoil the stock market party, at least not yet. For a more persistent fall in the S&P 500 and risk assets, strategists at HSBC said interest rate expectations need to be climbing higher and the 10-year yield has to rise above 4.7%. “Until that is the case we’d view any fall in risk assets as an opportunity to scale up exposure,” they wrote in a note to clients.
RBC Capital Markets’ head of US equity strategy Lori Calvasina said that if the 10-year yield rises to 5.3% or more while stocks’ earnings yield stays stable, that would represent a range that has been historically troublesome for the stock market in the past. Whenever the spread between S&P 500 earnings yield and 10-year bond yield fall below -2 percentage points, the equity benchmark drops over the next seven and 12 months.
However, for now she said that earnings yield gap is “still in a favorable range for stocks, but is running out of wiggle room.”
