The relationship between high-flying technology stocks and U.S. Treasury yields has broken down, echoing ‘the extreme anomalies of the dot-com boom when tech valuations became unmoored,” according to Morgan Stanley.
“For most of the last 20 years, tech stocks have traded directionally with economic growth—carrying a positive correlation with long-duration Treasury yields—as investors viewed them as tied to positive economic growth,” Lisa Shalett, chief investment officer of Morgan Stanley’s wealth management business, said in a report this week. Now “bountiful liquidity” is distorting both interest rates and tech stocks, which are now negatively correlated at the lowest level since 2000, when the market saw an internet stock bubble.
This chart in Morgan Stanley’s report shows the relationship between the S&P 500 Information Technology Index and 10-Year U.S. Treasury yields since 1990.
“With tech trading at a 60% premium to an already expensive market, interest rate sensitivity is once again negative, suggesting any backup in yields will be a powerful headwind,” Shalett said in the report. “This index concentration in tech stocks increases market fragility.”
Major U.S. stock benchmarks — the S&P 500 Dow Jones Industrial Average and the tech-heavy Nasdaq Composite — have risen this year to a series of new records. Information technology is the largest sector in the S&P 500 index, FactSet data show.
“The second quarter closed with growth-dominated U.S. stock indexes at all-time highs and up more than 14% for the year to date, while value and cyclical stocks lagged despite forecasts for near 10% nominal GDP growth this year,” Shalett said in the report. “This dynamic may be explained by the 30-basis-point pullback in the 10-year US Treasury yield and a hawkish tilt by the Federal Reserve.”
The yield on the 10-year Treasury note declined about 30 basis points over the second quarter, slipping further in July to trade around 1.3% on Thursday afternoon. That compares with a yield of more than 1.7% at the end of March. Lower Treasury yields have been benefiting longer-duration, rate-sensitive growth stocks, with investors in recent weeks rotating into them from value and cyclical bets.
“The fall in 10-year Treasury rates simply bolsters long-duration assets,” Shalett said. “But is nearly everything now a long-duration asset?”
Stocks typically representing 20% to 25% of the S&P 500’s market value are considered “bond proxies,” because they rally when yields fall and vice versa, according to the report, which cited data from Empirical Research Partners. Today, stocks classified as “bond proxies” have increased to more than 35% of the index’s market capitalization, “and those stocks are disproportionately found among the megacap tech category killers,” the report said.
That may put portfolio diversification at risk.
“That megacap tech stocks have been behaving like bond proxies not only undermines portfolio diversification efforts but increases the stock market’s vulnerability to a pickup in rates,” Shalett said in the note. “Tech stocks are only priced to yield about 130 basis points more than the 10-year Treasury.”
Meanwhile, the U.S. stock market was trading broadly lower on Thursday, with all three major benchmarks down nearly 1%.
“In a market awash with liquidity, a zero lower bound on the fed funds rate, extreme stock valuations, bond indexes at above-average duration and corporate credit spreads at historic tights, interest rate sensitivity has rarely been greater,” Shalett warned in the report.