The “high yields” issue
It is unclear how much higher the benchmark yield will rise. Some strategists believe the 10-year yield will rise above this year’s high of around 1.76 percent before the end of the year.
This is due to the fact that investors rely on those stocks for future growth and cash flow, and as interest rates rise, the value of that cash flow decreases or is discounted.
The 10-year yield hit 1.56 percent on Tuesday, up about a quarter percentage point from when the Federal Reserve met last Wednesday. The Nasdaq fell 2.3 percent on Tuesday. Alphabet dropped 3.5 percent, while Microsoft dropped 2.7 percent. For example, the ARK Innovation Fund fell 3.7 percent.
Yields had fallen from the year’s highs in March and April as a result of resurgent Covid, concerns about a slowing economy, and technical factors. In early August, the 10-year yield fell as low as 1.12 percent. Rising inflation and the Federal Reserve, however, are among the factors driving yields higher, as Covid cases appear to be dwindling and the economy is expected to improve.
“I believe the yield correction is over, unless there is some other exogenous event in the markets,”. “We re-established the trend…toward higher yields, which could result in a break up above this year’s highs in yields above 1.75 percent.” Morgan Stanley has set a year-end target of 1.8 percent.
The Fed was a driving force behind this recent move, and many bond analysts expected yields to rise to between 1.55 percent and 1.60 percent from around 1.31 percent just after last week’s meeting. The rise in yields has been global, as other central banks have signaled their readiness to abandon easy policies.
Bond strategists believe that enough has changed in the last week to propel the yield, or rate, back to where it was earlier in the year and then some. However, interest rates will remain relatively low, with the Fed expecting its own fed funds target rate to reach 1.75 percent by 2024.
Last week, the Fed signaled that it was nearing the end of its bond-buying program. That means the Fed will gradually reduce its monthly purchases of Treasury and mortgage-backed securities worth $120 billion. It also issued a more aggressive rate hike forecast, with half of officials now anticipating at least one hike next year. Since then, Fed Chairman Jerome Powell has warned that higher inflation may last longer than previously anticipated.
This year, Pimco expects the 10-year yield to range between 1.5 percent and 2 percent.
“If you want to call it that, it’s a resetting… a return to the previous range, which is widely expected to be in the 1.5 percent to 2 percent range,” said Tony Crescenzi, executive vice president and portfolio manager at Pimco. “Typically, the stock market worries about the speed of the move and the destination, but when the yield climb slows and eventually stops, the stock market looks at the absolute level and begins to worry materially less because the profit outlook is quite good.”
According to Crescenzi, the stock market will adjust and rise, and stock investors may be content with a 10-year yield of 1.5 percent to 2 percent.
“We would be overweight equities for the next one to two years due to the positive outlook for the US and global economies,” he said. “We anticipate that GDP will be around 4% next year.” That is a very good number, with Dow Jones earnings growth in the double digits.”
Rising interest rates aren’t all bad, and higher yields, as long as they don’t rise too quickly, may give investors more confidence in the economy’s recovery.
According to Ben Jeffery, fixed income strategist at BMO, the move indicates a growth-related move rather than an inflationary one. The stock market’s decline could also act as a dampener on the yield move, causing investors to seek safety in bonds.
Jeffery stated that his next 10-year target is 1.60 percent, followed by 1.70 percent. “If we get close to 1.70 percent, there will be some pretty significant buying interest,” he predicted.
According to Emanuel, if Washington does not pass a spending bill and interest rates continue to rise, the stock market will be concerned about inflation. Stocks would be concerned if the 10-year yield returned to the 1.75 percent range it was in earlier this year.
“Above the year’s high of 1.77 percent is a signal to the market that the abnormally low interest rate era has officially ended,” Emanuel said. He predicted a stock market correction, but believes the market will resume its upward trend in the fourth quarter.
Other forces, according to Crescenzi, are also at work to push yields higher. For example, in September, there is typically a large amount of corporate issuance, so buyers shift from Treasurys to that market. With the rise in stock prices, pension funds are also becoming more fully funded, so they are replacing some of their equity holdings with longer-term bonds.
“What motivates some investors to sell is persistence – the persistence of slightly higher inflation, which is evident again in the run up in energy prices and all the commotion about shipping problems,” Crescenzi said. “There is persistence in supply-side issues, persistence in longer-term inflation expectations, and persistence in the Fed. It is proceeding with its plan to taper and eventually tighten. The taper does not specify a target date for tightening, but the clock begins to tick once the taper begins.”
Crescenzi predicts that inflation will begin to slow next year.
“There are already a lot of rate hikes priced in, so there isn’t much more upside to yields that is likely to be tied to the Fed,” he said. He believes that the move in the 10-year yield can be contained simply by the impact of higher interest rates.
“The higher the yield, the more likely there will be spillover effects into other markets.” “As a result of the spillover, investors return to bonds, and the market stabilizes,” he said. He also stated that higher U.S. yields will continue to entice foreign investors.
Rising bond yields could help long-term investors
“Rates is a big number. If the economy is expanding and strengthening, and there is pent-up demand and shortages, resulting in reflation and higher interest rates, that is obviously very good earnings. It’s good for return on investment and means higher interest rates,” Lee explained.
“However, that was the environment from 1950 to 1970. “I think anyone who really studies markets would understand that rising rates aren’t a killer for the equity market,” added Lee.
Lee’s remarks came as Wall Street struggled, with the tech-heavy Nasdaq leading the declines with a 2.8 percent drop. The Dow Jones fell about 2.1 percent.
Higher interest rates are especially harmful to growth stocks, many of which are in the technology sector. One reason for this is that low borrowing costs can aid in business expansion. Another reason is that higher interest rates change a key variable that investors use to discount future cash flows, which can compress equity valuations.
For the month, all three major US indexes were in the red. However, when looking at the big picture, Lee believes the market and economy have shown resilience. He went on to say that he believes “demand for tech products” will continue to rise. “I think these are reasons why investors should look past the short-term pain, and I don’t think it changes the probability of a big rally into year-end,” he said.
Lee stated that he is unconcerned about lower revisions to economic growth forecasts, at least in terms of where the market can go.
“If someone says, ‘Well, third-quarter GDP numbers are going to be cut, or earnings are going to miss, so stock markets are topping,’ that must mean there have been 100 stock market tops just since 2010,” Lee said. “I think what we have to remember is that bull markets end when the economy itself exhausts capital, as if there are no strong returns to be earned.”
“We’re in a situation where there are supply-chain issues. It’s causing delays and price increases, but it’s not creating an environment where profit margins are collapsing,” said Lee, the former JPMorgan chief equity strategist. “Profit margins collapse when there is a demand problem, companies are unable to pass on price, or investors overprice things.” To my knowledge, it has never happened in the first year of an expansion.”
The “sell growth stocks’ fear
The rise in government bond yields is global, as are the price pressures caused by scarcity. The shape of the 19-year German bond yield chart is nearly identical to that of the 10-year US Treasury note. Still far from worrying absolute yield levels, but it’s a good prod for the familiar “sell growth stocks” reflex that has a disproportionate impact on the Dow Jones.
The index is now about 1% higher than last week’s intraday low, which was only a 5% drop from the record Sept. 2 high. As I mentioned last week, we had a similar setup a year ago, but with a larger amplitude (10 percent drop from Sept. 2 peak, 8 percent to 9 percent bounce and a retreat to retest around the 100-day average).
The rotational action is striking, but it is not novel. This year, the Dow Jones Pure Value index is outperforming the Nasdaq 100. From June to September, cyclicals and values were corrected. That is the scenario that has priced in much of the delta summer slowdown story.
We should note that the relationship between higher yields and lower growth-stock prices has a quantitative academic rationale, but it is not a natural law. It appears that some additional boost to Big Tech’s valuation premium has been sustained here, with a cover story claiming that “low absolute rates and negative real yields inflate the value of tech’s consistent cash flow streams.”
In the short term, a rise in real yields activates the sell mechanism. Perhaps a good reason to reallocate toward cyclical/reflationary assets. However, nothing specific about 1.5 percent Treasury yields computes with any precision to, say, a 25x forward P/E versus the Nasdaq 100’s current 27x.
Of course, there aren’t many outright winners today, with energy stocks up modestly and regional banks holding steady. As bonds provide no protection, we are reducing our exposures across the board.
The yield and inflation story (home prices ripping, power prices not letting up) has been exacerbated by lingering concerns about corporate margins and the setup for third-quarter earnings. Total absolute numbers may still be too low, but analyst revisions have weakened and companies will likely be less of an all-out beat-fest.
Debt-ceiling/budget gamesmanship isn’t helping, but it’s difficult to interpret today’s events as a debt-ceiling tantrum. Treasuries would almost certainly rally rather than sell off in such a panic. Questions about the Fed’s composition (two hawkish/inflation-averse regional presidents resigning, harsh words toward Powell on the Hill) are also unhelpful, but remain at the noise level.
There’s a whiff of 2011 in the air – concerns about the sustainability of an economic recovery, oil surging, and the U.S. debt ceiling drama. When it came to raising interest rates, the ECB made a mistake. That is unlikely to happen now, though the market is clearly bracing for marginally less generous central bank policy combined with a softer economic footing, a combination that has caused market volatility in the past.
Still, with reopening momentum in the United States, a tight labor market, income gains, record household net worth, and flush corporate cash flows, it’s difficult to be too concerned about where this is all going.
Today’s market breadth is poor, but it isn’t quite a headlong liquidation. The NYSE has a 1:3 up:down volume ratio, while the Nasdaq has a worse ratio. The Dow Jones equal-weighted index is outperforming, while mega-caps are down more than 2% as a group.
Because we were just at these levels, the VIX is perking up, but it is not as responsive to this sell-off as it was to last week’s. Returning to last week’s Dow Jones lows with a VIX lower than the 27.5 level printed last week would be a good sign for bulls.