Does divergence of S&P 500 and treasury yields pose threat to equities?

By Matt Weller

After a dismal start to the month, the S&P 500 (CME:SPZ14) rallied to a record high last week and is nearing an important psychological resistance zone around 2,000.

If the index manages to break through this level, it should bode well for US stocks in the near-term. The strong performance of US stocks over the last couple of weeks can be attributed to easing geopolitical tensions, a strong earnings season and encouraging US economic data, which helped the market brush off mildly hawkish minutes from the Fed last week.

On the data front, the optimism surrounding the US labour market has been bolstered by strong US housing and manufacturing data. It’s worth pointing out that while the economic data out of the US has been broadly positive lately, it hasn’t materially changed the market’s perception on when the Fed will begin hiking interest rates. Thus, it’s supportive for US equity markets.

S&P 500 (white) and U.S. 10-year Treasury Yield:Source: FOREX.com, Bloomberg (Note: This chart may not represent prices offered by FOREX.com)

In the QE era, strong US economic figures can result in a negative reaction from U.S. stocks because it makes the market jittery about the prospect of higher rates. This time is different because the market’s expectations for monetary policy haven’t really been altered, despite the general feeling from the Fed’s July policy minutes that the doves are moving closer to becoming the minority.

At the same time, second-quarter earnings season has also helped to bolster investor sentiment. Of the 486 companies in the S&P 500 that have reported earnings at the time of writing, more than 75% of have topped analysts’ estimates. This bodes well for the index leading into a period of expected increased sales and revenue for many firms.

With the US earnings season almost over, the biggest threats to our bullish outlook may come in the form of increased geopolitical tension or a more-hawkish-than-expected Fed. As we pointed out earlier, the Fed’s latest meeting minutes were slightly more hawkish than the market was expecting, but the outlook for rates remains very data-dependant. In the event of strong growth and labour market indicators the Fed may elect to bring forward the beginning of its rate-tightening cycle. Yet, this won’t necessarily result in equity weakness; the Fed’s tightening cycle is likely to be gentle and measured, which makes it manageable.

At the time of writing, the market is eagerly awaiting a speech from Fed Chair Yellen in Jackson Hole, where she will talk about the labour market. The health of the jobs market is a crucial factor in determining when the Fed will begin hiking interest rates. July’s meeting minutes suggested that policymakers differ in their views of the labour market and how best to accurately assess its real health. Overall, despite the more hawkish minutes, the market largely expects Yellen to sound more dovish.

From a technical perspective, all eyes are on 2,000. This level represents a key psychological resistance zone for the S&P 500. A break here could extend the current rally even further into unknown territory. If the index is rejected by the aforementioned resistance zone it may head towards trend line support (see chart). A break of its upward trend would negate our overall bullish view of the S&P 500.

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