Yields Up, Stocks Down

Now that fears of a deflationary spiral have waned, a rising Treasury note yield is bearish for stocks. Rising Treasury yields increase mortgage rates and decrease the attractiveness of rate-sensitive stocks like utilities, banks, and REITs.

A rising trend in Treasury yields is especially dangerous when you consider that the biggest threat to the economy in 2010 is the backlog of mortgage foreclosures that have yet to work their way through the system. As these homes work their way through the system, it will be another deflationary shock to the banking system. In this deflationary shock, I doubt we’ll see Treasury yields move anywhere near their 2008 lows. Higher Treasury yields will keep pressure on interest rate-sensitive stocks, while the continued deflationary pressures in housing will keep pressure on credit-sensitive stocks.

All of this adds up to a much more hostile environment for the stock market than we’ve seen in 2009. With valuations high, long-term interest rates heading up, and credit stress still an issue, the environment for short selling is growing more favorable.

And according to Ian Mathias of The 5 Minute Forecast. “[The US Treasury] will auction $44 billion in two-year notes today, the first of three auctions this week that will net a record-tying $118 billion in IOUs.”

Since the Fed has jawboned interest rates in the shorter end of the yield curve down to record low levels, the Treasury is finding it incredibly cheap to finance the deficit. But this will not last forever – especially at the longer end of the yield curve. It will gradually become more expensive to refinance the national debt, which will suck capital away from the private sector.