By Justin Lahart 

The convulsions that the Treasury market sent stocks into over the past couple of weeks are something that investors should probably get used to.

With Covid-19 cases falling, millions of Americans receiving vaccinations each week and another round of government relief looking likely, expectations have been ratcheting higher for how quickly the economy will grow this year. At the start of January, economists polled by IHS Markit forecast gross domestic product would be up 4% in the fourth quarter of 2021 from a year earlier; now that figure stands at 5.5%.

Expectations of a stronger economy count as a positive development for companies' earnings prospects, but they are also pushing long-term interest rates higher, with the 10-year Treasury recently yielding 1.47% versus 0.93% at the start of the year. That isn't unusual, since long-term rates typically go up as the economy's prospects improve, but then again stocks haven't tended to be as expensive at the start of recoveries as they are now.

The S&P 500 trades at about 22 times analysts' expected earnings over the next year, according to FactSet, which is close to its highest forward price-earnings ratio in 20 years. In December 2009, six months after the last recession ended, the S&Ps forward price/earnings ratio was about 14.

As a result, even relatively modest moves upward in Treasury yields, and therefore the relative attractiveness of bonds to stocks, can cause market spasms. This is particularly true of the richly valued technology shares that have been among the biggest market winners since last spring.

So long as rising Treasury yields are driven by an improving outlook for the economy, the stock market may be able to absorb higher long-term rates. But that doesn't mean the process will be smooth. One issue is that rather than gradually drift up, Treasury yields may instead have long periods where they stay relatively steady, and then jump quickly.

Layer in the Federal Reserve. Officials at the central bank have made clear that they plan to leave short-term rates near zero and keep buying Treasurys and mortgage securities until the economy is well on the way to health, but if the Covid crisis really does fade, Treasury investors may question the Fed's commitment to keep buying assets in particular. That could lead to paroxysms in the bond market that agitate stocks as well.

It isn't hard to envision situations in the months ahead where the Fed worries the Treasury market is getting ahead of itself and feels a need to calm the waters.

If the economy really does improve through the course of the year -- an eventuality that, of course, depends on the fight against the pandemic going well -- the stock market could be in for a period of general optimism punctuated by panicked, rates-driven selloffs. In other words, the market's recent displacements could be just a preview of what is to come.

Write to Justin Lahart at justin.lahart@wsj.com

(END) Dow Jones Newswires

March 03, 2021 16:50 ET (21:50 GMT)

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