The rates trade is back in focus for stock investors

Wall Street is worried that the rates trade could once again drag down stocks.

The 10-year Treasury yield (^TNX) has risen roughly 25 basis points in the last 10 days alone. It’s now hovering around 4.32%, just shy of levels Morgan Stanley chief investment officer Mike Wilson recently noted could be a critical level for stock investors.

“We view 4.35% on the 10-year US Treasury yield as an important technical level to watch for signs that rate sensitivity may increase for equities,” Wilson wrote in a note to clients on Sunday.

Bank of America’s March Global Fund Manager Survey released on Tuesday shows that 40% of managers expect lower bond yields, down from the 62% seen in December. This marks the lowest expectations for yields to fall seen in the last year.

Wilson noted that large caps have become less sensitive to rates recently. “Small caps are likely to show more rate sensitivity than large caps on a move higher in yields,” he said.

This strength in large caps, Wilson points out, has played out in the recent broadening of the market, which has kept the S&P 500 (^GSPC) near record-highs despite the market scaling back its bets on rate cuts by the Federal Reserve. Sectors like Materials (XLB) have recently caught a bid while the Russell 2000 small cap index (^RUT) has continued to lag.

The key for equity markets will be if the rate uncertainty continues. Many strategists have told Yahoo Finance for a full broadening to occur in the stock market rally, investors will likely need to be more confident in the Federal Reserve’s plans for interest rates. The central bank will announce its next policy decision on Wednesday.

While markets don’t expect news of an interest rate cut, investors will likely gain some clarity on the Fed’s thinking through its Summary of Economic Projections.

The release includes the “dot plot,” which maps out policymakers’ expectations for where interest rates could be headed in the future. In December, the dot plot showed Fed officials projecting three interest rate cuts this year. But after several hotter-than-expected inflation reports and no signs of an economic slowdown, economists have warned the Fed may project fewer cuts.

“The potential removal of an expected cut would be taken as hawkish by the market, putting upward pressure on rates and the [US dollar]all else equal,” Bank of America’s rate strategy team wrote in a research note on Wednesday.

BlackRock senior investment and portfolio solutions strategist Kristy Akullian told Yahoo Finance Live that some of the stock reaction one would expect from a move in Fed rate cut expectations has likely been “priced in.” But areas outside of large cap stocks could still feel some pain.

“It can matter for the lower quality part of the market,” Akullian said. “So if we look at small caps and highly levered companies, they’ve struggled this year and I think they can continue to struggle.”

WASHINGTON DC, UNITED STATES - MARCH 6: Jerome Powell, Chairman of the US Federal Reserve, makes a speech during the House Financial Services Committee hearing at the Rayburn House Office Building in Washington DC, United States on March 6, 2024. (Photo by Celal Gunes/Anadolu via Getty Images)WASHINGTON DC, UNITED STATES - MARCH 6: Jerome Powell, Chairman of the US Federal Reserve, makes a speech during the House Financial Services Committee hearing at the Rayburn House Office Building in Washington DC, United States on March 6, 2024. (Photo by Celal Gunes/Anadolu via Getty Images)

WASHINGTON DC, UNITED STATES – MARCH 6: Jerome Powell, Chairman of the US Federal Reserve, makes a speech during the House Financial Services Committee hearing at the Rayburn House Office Building in Washington DC, United States on March 6, 2024. (Photo by Celal Gunes/Anadolu via Getty Images) (Anadolu via Getty Images)

Josh Schafer is a reporter for Yahoo Finance. Follow him on X @_joshschafer.

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