The decline in US government bond prices since the start of the year poses a threat to Wall Street's recent rally, according to many analysts and investors.

High prices and low U.S. government bond yields have provided important support for Wall Street since the Covid-19 shock created last year. However, with inflation expectations rising, US government bond yields were also boosted. The 10-year bond yield this week touched 1.3%, the highest since February 2020, up from 0.9% at the beginning of the year. Additionally, February is usually one of the months with the biggest increase in bond yields since 2018.

Investors are looking to identify potential reversal points in the stock market.

“If yields are to rise steadily this year and next, the stock market will be happy,” said Kiran Ganesh, multi-asset strategist at UBS Global Wealth Management. “If things go a little too quickly… that could lead to more serious problems.”

Trends in 10-year US bond yields. Unit: %

The prospect of an economic support package of $1.9 trillion from the administration of President Joe Biden, the recovery of demand after months of social restrictions to cope with Covid-19 and the loosening monetary policy from the Fed pushed up inflation expectations. to the highest level in many years. A measure taken from US inflation-resistant government securities (TIPS) - the 10-year breakeven rate - is now at 2.2%, the highest since 2014.

So far, the personal consumption expenditures (PCE) index - the Fed's preferred inflation measure - in December 2020 is 1.5%, below the US central bank's long-term target. In January, the consumer price index (CPI) - another measure of inflation - increased by 0.3% while the previous month's figure was 0.2%.

Inflation is the "fix" of bonds, reducing the value of fixed payments to investors.

With the stock market, moderate inflation is usually a good thing. Sean Markowicz, investment strategist at Schroders, calculates that the US stock market typically outperforms 90% of the time inflation stays low and then picks up. Any inflation stemming from the return to normal life is a welcome signal, showing that the US economy is gradually coming out of the recession caused by the Covid-19 pandemic.

The stock market may be more explosive than previous inflations. Bond yields are still relatively low. And it's important that the Fed makes it clear that it's content, allowing inflation to simmer without having to raise interest rates. However, investors warn that rising prices too quickly could affect Wall Street, which is around historic peaks, especially in the technology sector.

Strong inflationary pressure can erase the extra revenue because input costs increase accordingly, affecting profits. Rising interest rates also reduce the present value of a company's future cash flows, constraining the value of its stock.

“The market will always deduct those future cash flows at a higher rate, when inflation rises, to make up for the loss of money,” Markowicz said.

The task now is to determine when these dynamics emerge, according to investors.

“It is quite difficult,” said Jeffrey Palma, public investment lead of the global trust solutions group at State Street Global Advisors. But a “steady” increase in breakeven above 3% would “lead to a time when the yield curve makes stocks less stable.”

The breakeven rate of a 10-year US government bond. Unit: %.

Analysts at Goldman Sachs recently calculated, based on historical data, that interest rates need to rise 0.36 percentage points per month for Wall Street to shake.

Deepak Puri, chief US investment officer at Deutsche Bank Wealth Management, thinks 10-year bond yields “need to be at least above 1.75% to be enough to distort the supposedly best structure of the equity market. ".

Expected inflation, if it remains positive, can help rebalance the stock market, cool down strong growth areas such as technology, and promote hated sectors such as finance and energy – often positive developments. following the rise of inflation.

The worst time risk appears as early as the summer of this year, investors said. They forecast the US economy will "roar" again then, mainly thanks to the additional economic support package. Treasury Secretary Janet Yellen recently reaffirmed the need for "strong action" in financial support to boost the US economy. Fed Chairman Jerome Powell also emphasized his commitment to a "patiently supportive" monetary policy.

“At some point this summer, we will see inflation rise and exceed target, GDP is strong, interest rates are near zero and monetary policy is pumped in,” Ganesh forecast. “The Fed tells us everything is going to be fine, we think so… but reality leads to anxiety.”

Golub says anxiety can create "long-lasting pain" for stock investors, especially if the rise in consumer inflation is hard to control.

“If inflation starts to run… the market will see that as a very, very bad thing,” he said. “Suddenly, the party ended.”