(The opinions expressed here are those of the author, a

columnist for Reuters.)

By Mike Dolan

LONDON, May 27 (Reuters) - U.S. stocks and bond yields

have been rising in tandem in recent weeks, with many investors

attributing the move to the Iran war, inflation and an AI arms

race. But some models now suggest higher borrowing costs are

reaching the point where they start to drag on equities.

Calculations on so-called equity risk premia (ERP) - the

excess returns promised by holding equities over those on

"risk-free" government bonds - differ widely depending on inputs

and methodologies.

Yet Societe Generale's proprietary version, which the bank

updated last week, reckons nominal U.S. Treasury yields at 4.5%

are a critical juncture for relative value between the two asset

classes.

The SG team finds the correlation between equity prices and

bond yields is not static and, historically, this link turns

strongly negative when bond yields push through 4.5%. Ten-year

Treasury yields broke through that level briefly

last week before hovering right on it on Tuesday, with the war

still unresolved.

"This essentially means that once U.S. Treasury yields are

above 4.5%, any further increase in bond yields is broadly

negative for equity markets," they wrote. The ability of U.S.

equities to absorb higher bond yields, they added, is now

limited.

That puts the next steps in the Iran conflict and the

disrupted Strait of Hormuz at a potential tipping point for

broader financial markets through midyear.

Since the war started on February 28, the 10-year yield has

climbed by more than 50 basis points. Equities juddered on the

initial oil shock but have since bounced back almost 20%, lifted

by a technical ceasefire at the start of April and a sharp

upgrade in AI-related profit estimates during the U.S. earnings

season.

With U.S. inflation running hot and Federal Reserve

officials turning hawkish, bond yields have taken another sharp

leg higher this month. Oil analysts doubt that even an immediate

end to the war would resolve all supply problems this year. The

risk for central banks is that entrenched inflation forces them

to tighten monetary policy further.

And at current levels of longer-term bond yields, we may be

at an inflection point for stocks as well.

SocGen calculates the U.S. equity risk premium has fallen to

about 3.5% - close to the 3% threshold where it sees equities

starting to struggle against more attractive bond returns.

MODELS AND FRAMEWORKS

In context, the ERP was above 7% after U.S. interest rates

were cut to zero following the banking crash in 2008 and the

COVID-19 pandemic in 2020, and stood above 5% before the Fed's

rate-hike campaign in 2022.

To understand how SG arrives at its figures: the U.S. cost

of equity has remained above 7.8% this year. That expected

return is the discount rate at which the present value of all

future dividends equals the current index level.

SG's dividend discount model is divided into four stages.

The first three years are taken from consensus earnings

forecasts; the next three are drawn from 10-year average

earnings growth; then a nine-year period of linear decline to

what it defines as a "perpetual" earnings growth rate equivalent

to the 10-year average nominal GDP growth rate.

Any sudden downshift in these inputs, from a growth or

earnings surprise, for example, would put the ERP in the danger

zone even without further bond yield gains.

But that's just one model. Others are signalling alarm

already.

JPMorgan's proxy for the ERP, which it sees as the gap

between the equity discount rate of the S&P 500 and the

real 10-year Treasury yield, has fallen to just 2.2% - a level

it says is a new low for the post-financial-crisis period since

2007.

That is 90 basis points below JPM's long-term historical

average.

"While it is still some way above its 2000 trough, this

implies that there is currently more limited room before a

further rise in bond yields starts becoming a problem for the

equity market and that from a long-term asset allocation point

of view," JPM strategist Nikolaos Panigirtzoglou wrote.

There are differences in the models, obviously. JPM uses a

two-stage dividend discount model and a real Treasury yield

adjusted for rolling inflation expectations.

But both are clearly signalling that the AI-led equity boom

faces a harder road at current yield levels.

The AI theme has swept away myriad market concerns over the

past three years. Unless the Iran conflict ends swiftly - and

fixes a smouldering inflation and interest rate problem with it

- the AI rally may have a great deal more sweeping to do.

(The opinions expressed here are those of Mike Dolan, a

columnist for Reuters.)

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