Dwindling Equity Risk Premium Can Lead to a Severe Stock Pullback

US Treasury yields have been hitting record highs lately as the Federal Reserve’s hawkishness puts bonds under severe pressure. Surging yields have also eroded the equity risk premium to a 20-year low, a measure used by investors to gauge the stocks’ return potential compared to bonds. 

Bond Market Rout Deepens Amid Fed’s Hawkishness 

A rout in government bond markets has been taking a fresh downturn recently, pushing benchmark US yields to the highest level in 16 years. The yield surge comes as investors reacted to the Federal Reserve’s ‘higher for longer’ rates narrative, which could restrict economic growth and weigh on appetite for risk assets like stocks. 

The Fed and other global central banks have been hiking interest rates almost non-stop since March 2022 to bring down record-high inflation. Despite this particularly hawkish campaign, inflation stood at 3.7% in August, notably higher than the central bank’s 2% target.

In addition, the US labor market also remains red hot, with the latest data revealing that the US added 336,000 jobs in September, nearly twice the economists’ projection of 170,000. Given these circumstances, the Fed pledged to keep interest rates high for longer. 

These warnings exacerbated the bond market downturn, propelling yields to multi-year highs. Moreover, this upswing also battered the equity-risk premium – a measure of the reward for holding stocks over government bonds – pushing it to a 20-year low. 

Join our Telegram group and never miss a breaking digital asset story.

Stocks’ Low Return Potential Could Push Investors Toward Bonds

Notably, the earnings yield of the S&P 500, which reflects expected profits for the next year, was only 0.766 percentage points higher on Friday compared to the yield on the 10-year Treasury. According to Dow Jones Market Data, this represents the smallest gap between stock returns and safer bonds since June 2002.

The slump in the equity-risk premium could encourage investors to rotate away from equities into less-risky bonds and ultimately put downward pressure on stock prices in the short term. 

The number of stocks tracked by the S&P 500 index hitting new intraday 52-week lows recently hit the highest since October 2022. Meanwhile, the portion of stocks trading above their 50-day moving averages is at its lowest in a year, Dow Jones Market Data showed. 

Remarkably, the bulk of S&P 500’s gains this year were fueled by so-called “Magnificent Seven” companies thriving on the ongoing artificial intelligence (AI) boom. These stocks collectively soared over 50% year-to-date, while the remaining 493 stocks within the benchmark index gained about 5%.

Considering the current macro climate, do you think US equities are set for a significant pullback? Let us know in the comments below.