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As Treasury yields wobble, equities rally pushes forward

U.S. government bond yields have plummeted in July, but they may have hit bottom as investors look toward the potential tapering of quantitative easing and the prospect of more Treasury supply later in the year.

Analysts from Schwab Center for Financial Research and TD Securities see rates rebounding to as high as 2% through year-end, reversing course after a July slump caused by rising inflation and fears that the delta coronavirus variant could upend the ongoing economic recovery. The benchmark U.S. Treasury 10-year yield fell to 1.3% on July 8, its lowest settlement since Feb. 18.

"Given the steepness of the drop to date and the plunge in real yields, we believe there is likely more upside than downside from here," said Kathy Jones, managing director and chief fixed-income strategist at Schwab Center for Financial Research. Bond yields will likely remain in a "volatile range" for the rest of this year, Jones said, with the 10-year yield falling as low as 1.2% and rising as high as 2%.

Investors put just $955 million into mutual funds that invest in U.S. bonds on July 8, a slump of more than 80% from a week earlier, EPFR data show. The slump in yields has helped stocks hit record levels because investors have snapped up equities in search of higher returns.

Corporate earnings have also benefited from low borrowing costs, and the Fed is likely to remain "quite accommodative" for the rest of the year, said Gennadiy Goldberg, a senior U.S. rates strategist with TD Securities. The Federal Reserve will likely keep interest rates near zero and wait until December to announce tapering, Goldberg said. "However, the approaching end to [quantitative easing] and more Treasury supply amid the likelihood of additional stimulus later this year should push rates higher."

The 10-year yield will likely range between 1.5% and 1.75% into the fall and then end the year at 2%, Goldberg added.

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Stocks and Yields

Higher bond yields could derail recent stock gains.

In a July 9 note, economists with Goldman Sachs forecast the S&P 500 to end 2021 at 4,300, down about 2% from where it was trading on July 13. That forecast assumes that the 10-year Treasury yield will rise to 1.9% by the end of the year, up more than 50 basis points from where it is trading this week.

If the benchmark yield rises to a more modest 1.6% by the end of 2021, Goldman economists forecast that the S&P 500 will rise to 4,700, up about 7% from where it was trading July 13.

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The index has already climbed nearly 17% this year, helped by the slump in Treasury yields. This month alone has seen four record highs, led by demand for growth stocks, amid the low debt yields. The S&P 500 has closed at a new record high 39 times in 2021, on track to beat the previous record for 77 record high settlements in a year, set in 1995, according to S&P Dow Jones Indices.

The Nasdaq composite index, meanwhile, has settled at four new record highs in July, while the Dow Jones Industrial Average has hit two record settlements.

"Low bond yields tend to be good for equities," said the Schwab Center's Jones. "Unless the drop in bond yields reflects worries about an impending recession, it's generally a positive."

Continued low bond yields could push the rally in equities further, said John Stoltzfus, chief investment strategist with Oppenheimer Asset Management.

"The rally … now appears to illustrate a beginning of a broadening appetite for equities by both institutional and private investors," Stoltzfus said.