Treasury yields are likely to fall. That doesn't mean stocks and corporate bonds are guaranteed to increase.

By Frances Yue

Long-term Treasury yields are likely to fall by the end of the year, but it may not keep stocks and corporate bonds rising, according to Capital Economics.

The 10-year BX:TMUBMUSD10Y and 30-year BX:TMUBMUSD30Y Treasury rates have pulled back, respectively, from their 16-year high reached last week. The 10-year Treasury yield fell 6.5 basis points on Friday to around 4.637%, and the 30-year Treasury rate lost 7.5% basis points to 4.784%, according to MarketWatch data.

The retreat of Treasury rates helped support the gains of U.S. equities and corporate bonds earlier this week, with the Dow Jones Industrial Average DJIA on track to end the week higher.

But the situation is unlikely to hold, Hubert de Barochez, market economist at Capital Economics, wrote in a recent note. While Treasury yields may continue to fall, "we think that Treasuries' relationship with corporate bonds and equities will break down in the near-term, before reasserting itself next year," de Barochez said.

Read: Time for big shift from stocks to credit as 'easy money' ends, says billionaire investor Howard Marks

De Barochez said they expect the 10-year Treasury yield to drop by roughly 80 basis points by the end of the year, as growth falters in the U.S. with the economy possibly falling into a mild recession. "We suspect that this will help push inflation down more quickly than most anticipate. All this will in our view give the Fed enough reasons to cut rates sooner and by more than what is currently discounted in the markets," de Barochez noted.

For corporate bonds, a further decline in risk-free rates could be offset by widening spreads, as economic conditions deteriorate, according to de Barochez.

Credit spreads refer to the compensation investors can earn on corporate bonds versus the risk-free U.S. Treasury rate. The gauge tends to widen in jittery markets or when economic growth looks likely to slow, which can make investors more wary about not getting paid back in full if corporate defaults climb.

For stocks, lower Treasury yields mean a lower rate at which investors would discount companies' future earnings, which could be offset by pressure on valuations.

The equity risk premium, or the compensation investors can earn on stocks versus the risk-free U.S. Treasury rate, is likely to rise, meaning that the earnings yield also goes up, thus earnings per share would fall.

"We think that expectations for earnings, which have risen in recent months, will fall back," noted de Barochez.

Based on that, the firm continues to expect the S&P 500 SPX to end the year at around 4,200, about 4% lower than its current level.

Still, in the longer term, a recovering economy could help lift up corporate bonds and equity prices, especially with a revived hype around artificial intelligence, noted de Barochez.

U.S. stocks traded mixed Friday, with the Dow Jones Insutrial Average up 0.1%. The S&P 500 traded down 0.5% and the Nasdaq Composite COMP fell 0.2%, according to FactSet data.

-Frances Yue

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10-13-23 1433ET

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