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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 US10YT=RR 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 .SPX 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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