The market is right to be afraid of rising bond yields
No one likes to lose money, but Tuesday’s drop in stock prices worries me more than the stock of a 2% drop in the S&P 500 should. In itself, 2% is not a big deal: three days this year have had larger falls, and on average we have had seven worst days per year since 1964.
What bothers me is that the rise in bond yields that triggered the drop was really quite small, and there could easily be a lot more to come. The 10-year Treasury yield rose only 0.05 percentage point, taking it above 1.5%, and the 30-year yield edged up to just over 2%. If this is the kind of response we should expect, then take out your tin hat. Yields need to increase four times as much just to get back to where they were in March.
Why, you might reasonably ask, are stocks suddenly scared of bond yields? In the boom through March, stocks and returns rose together, and over the past two decades, higher returns have generally been better for stocks. The difference is that investors see central banks becoming hawkish, even as economic growth slows, because they cannot ignore high inflation.
As Pascal Blanqué, chief investment officer of French fund manager Amundi, puts it, the fear is a rate hike driven by inflation alone pushing central banks to act, rather than a rate hike driven by economic growth pushing financial markets. central banks. This is the mindset that dominated investing until the late 1990s. If it fits, it marks a profound change.
In the long run, this would mean that bonds no longer provide a cushion when stock prices fall, making portfolios more volatile. In the short term, if the steep rate hike since the Federal Reserve meeting last week is the start of a trend, then stocks are struggling. On the other hand, if yields fall, it could be good for stocks, as it was on Friday, rather than bad, as has generally been the case for the past 20 years or so.
To see the threat, think back to the spring when yields were up. The outlook for inflation is roughly the same (investors see it as high but temporary). The outlook for economic growth is worse, which is less supportive of equities in general. But central banks have gone from being super-simple for an eternity or so to start talking about tightening.
This is the wrong kind of rising bond yields. When yields rose to their March high of 1.75% for the 10-year Treasury, stocks were in tears because yields were dragged down by the prospect of higher economic growth and therefore higher profits. important. Beaten value stocks and economically sensitive sectors have soared, while big tech and other growth stocks, as well as reliable sources of income known as quality stocks, have made a big splash. no side. After March, lower yields boosted growth and quality stocks again, while stocks and cyclicals deteriorated.
This time around, stocks are reacting as they do when yields rise due to a hawkish central bank shift. Large technologies, other growth and quality stocks have suffered the most, because their high valuations make them dependent on the profits projected in the distant future; higher yields make those future earnings less attractive compared to owning super-safe bonds. But without the prospect of higher economic growth to boost earnings, cheap stocks and cyclical stocks also fell as yields rose, albeit less than growth and quality.
There is huge uncertainty about the possible economic outcomes, so we shouldn’t just assume this week’s business model will continue. On the bright side, the increased capital spending and adoption of technology brought on by the pandemic could boost productivity more than labor shortages increase labor costs. This would curb inflation and accelerate growth. A decline in Covid-19 could ease pressure on manufacturing and shift spending towards services. On the negative side, soaring energy costs and rising prices due to widespread bottlenecks could hit households and further weaken the economy, even if inflation remains high – the dreaded stagflation scenario.
We should be even less confident about the reaction of central banks. I see twin triggers for the market reassessment. First, Fed policymakers have increased their dotplot forecasts for interest rates next year and the year after, as well as inflation. Second, the Bank of England, facing tightening energy prices and higher than expected inflation, has warned of a possible rate hike before the end of this year. A large number of emerging market central banks have also raised rates, as has oil producer Norway.
If the economy reacts badly to higher yields, however, the Fed and Bank of England may well revert to an ultra-dovish stance. The withdrawal of emergency measures from government spending in much of the world will also give the doves yet another reason to keep rates low.
Finally, there is uncertainty about the reaction of the market itself. Perhaps Tuesday’s bond moves were exacerbated by a combination of dynamic selling and returns (moving in the opposite direction to prices) breaking above the 1.5% threshold on the 10-year and 2% on the 30. years. It may not be a coincidence that stocks performed well on Friday once the 10-year fell back below 1.5%.
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Round numbers shouldn’t matter, but they often do, while momentum is temporary. Tuesday’s decision wasn’t prompted by any event of the day, so maybe the new hawkish tale won’t hold up. After all, it shouldn’t be a big deal to withdraw some monetary support when inflation is more than double the target and politics have never been easier.
Given Big Tech’s disproportionate share of the global market, investors in the S&P 500 must be convinced that if bond yields are going to continue to rise, it will be for the good reason of an accelerating economy, and not for the sake of it. bad reason for persistent inflation pushing central banks to act.
Write to James Mackintosh at [email protected]
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