Bond yields are up, stocks down, so what’s next
- Strong economic data and positive geopolitical developments have pushed bond yields higher.
- Notably, the benchmark 10-year U.S. treasury yield settled above 3.2% — a level not seen since May 2011.
- The rapid move higher in bond yields likely sparked increased volatility in the equity markets.
- Bond yields are likely to continue their uptrend as the U.S. economy moves further into its expansion – making now a good time to consider minor allocation adjustments to capture this trend.
A healthy normalization
Our belief is that bond yields generally fluctuate because of changing inflation expectations, economic growth, or the additional compensation rewarded to longer-term investors (term premium).
Based on the fact that the Institute for Supply Management’s (ISM) survey of the non-manufacturing sector reached a 20-year high, the unemployment rate reached a level not seen since December 1969, and average hourly earnings rose 0.3% from the month prior, it’s clear to us that last week’s move in yields was driven by economic growth.
Strong data, coupled with friendly terms of trade, reduced uncertainty and pushed bond yields higher. The term premium was also a culprit (figure 1), but inflation was an unlikely driver.
Source: Bloomberg, Federal Reserve Bank of NY, NYLI SAS. As of 10/9/18.
Likely to continue
Wage growth was relatively tame this month, but we wouldn’t be surprised to see a reading above 3% year-over-year later this year (admittedly, the markets might).
Even after eight hikes to the Federal Funds rate, the economy is growing above trend. The Fed will likely continue its gradual rate hike campaign longer than some investors once thought. Without significant core inflation pressure, we see little reason for the Fed to move more than one rate hike in December and three rate hikes in 2019. Higher interest rates at the short end have similar implications for the long end.
The term premium should also continue to normalize: Corporate pensions have reduced their buying of Treasurys and the Fed continues to do the same with balance sheet roll-off; meanwhile, higher volatility and a stronger dollar incentivize international investors to look closer to home – especially given higher yields. The factors above probably won’t dissipate quickly.
The bottom line: A strong economy and higher short-term rates, along with still-easy credit, lower tax rates, and reduced regulatory burdens are a formula for higher yields in the U.S. in the next year.
Implications for stocks
A rapid increase in bond yields can induce some stress on equities as investors adjust to new market conditions. This week’s equity sell off is a great example. The ten-year gained about 20 bps in one week – a relatively short amount of time. Subsequently, the S&P 500 fell sharply with the some of the biggest losses attributable to the best performing stocks this year (think tech and growth names). While these rate jitters are likely temporary, the selloff gained some steam when the S&P broke below a key technical level. Equities will likely face some key tests in the near term. Once the dust settles, we believe this may make a good buying opportunity.
Interest rates are higher because the economy is strong. A strong economy should also support equity prices heading into 2019. But more market jitters are likely on the way as financial markets participants question the late cycle environment. Sustained economic growth will likely mean that the Fed maintains its interest rate path of one additional hike in 2018 and three hikes in 2019. It is possible that the economy can handle higher interest rates than markets are willing to tolerate.
A strong economy with low inflation feels almost ‘too good to be true’, and yet, we remain bullish on equities relative to fixed income as the economy and profits grow. If bond yields resume their upward climb, longer maturity bonds will face headwinds. The prospects for shorter duration bonds may offer moderate positive returns.
Nevertheless, fixed income remains an important diversifier to investor portfolios, so we look for just that – diversification. Selective exposure to corporate bonds and municipal bonds may offer good diversifying properties, spread pickup, and the potential for some further spread tightening.
For those willing to bear more risk, leveraged loans offer more income with some collateral protection. That said, investors should express caution by taking a selective approach when focusing on higher quality, and larger, liquid loans.
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A portion of a municipal fund’s income may be subject to state and local taxes or the Alternative Minimum Tax. Funds that invest in bonds are subject to interest-rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, in which the bond issuer may fail to pay interest and principal in a timely manner.
Treasury Securities are backed by the full faith and credit of the United States government as to payment of principal and interest if held to maturity.
The 10-year Treasury note is a debt obligation issued by the United States government with a maturity of 10 years upon initial issuance. A 10-year Treasury note pays interest at a fixed rate once every six months, and pays the face value to the holder at maturity.
Institute for Supply Management (ISM) is the first and largest not-for-profit professional supply management organization worldwide.
The term premium is the compensation that investors require for bearing the risk that short-term Treasury yields do not evolve as they expected.
A yield curve is a curve on a graph in which the yield of fixed-interest securities is plotted against the length of time they have to run to maturity.
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