Rising Bond Yields Sting Equities
- Bond yields have risen dramatically, increasing equity market volatility.
- Stronger economic data and supply-demand imbalances have been the key causes.
- With our expectation that the Fed pauses, we think this could be an opportunity to buy bonds.
The stock market’s mood has changed since early August. After ending the first half up around 16%, the S&P 500 struggled in August primarily due to rising bond yields. Since July 19, the yield of the 10-year U.S. Treasury bond has jumped from 3.74% to 4.34%, largely due to economic resilience and supply/demand imbalances for U.S. Treasury bonds. Consequently, U.S. equity markets have struggled for direction. With rising yields becoming more attractive to income- seeking investors and the Federal Reserve (Fed) likely on hold for the foreseeable future, we do not expect yields to rise significantly higher from current levels and would incrementally add exposure based on your objectives.
Economic data over the past month, such as retail sales, industrial production, 2nd Quarter GDP, and early 3rd Quarter GDP indications, all suggest the U.S. economy is resilient. If the economy is stronger than expected, investors begin to anticipate inflation pressure and sell fixed- income securities consequently pushing higher bond yields. Further pressuring yields higher has been a supply/demand Treasury bond imbalance. On the supply side, the Treasury Department has been issuing more treasury bonds for funding needs and rising budget deficits due to slower tax receipts. On the demand side, the Fed continues its Quantitative Tightening program, where they have been selling treasury bonds each month. The Fed has been very adamant, through comments and last week’s FOMC meeting minutes, that they will maintain higher interest rates for longer. Higher interest rates reduce the incentive for investors to buy U.S. treasury bonds to lock in these higher yields. On the other hand, if yields were poised to move lower, investors would likely jump in to buy U.S. treasury bonds to lock in higher yields. Supply and demand of U.S. treasury imbalances have pressured yields higher. These considered, stronger economic data will likely cause the Fed to not cut interest rates anytime soon.
With bond yields moving higher, equity investors are worried for two primary reasons. First, higher yields equal higher borrowing costs for companies and consumers. Higher corporate borrowing costs may hurt profit margins and increase costs for new projects or other expansion plans. Higher consumer borrowing costs, such as mortgage rates or auto loans, may reduce consumer spending. Therefore, higher borrowing costs impacts economic growth and possibly corporate earnings.
The second reason why higher yields worry equity investors has to do with investment fundamentals around valuation. When an investor values a company, one common way is to look at future cash flows or earnings and attempt to determine what they are worth today. Because this valuation methodology relies on current interest rates to determine the present value of these future cash flows/earnings, higher interest rates or bond yields reduce stock valuations. Technology stocks usually struggle in a rising rate environment because rapid growth assumptions are usually built into their valuations. This explains why the Technology sector is the worst performing sector this month in the S&P 500.
Rising bond yields have been pressuring equities and driving a rise in market volatility. While uncertainty persists around Fed interest rate policy, we continue to believe that the Fed has paused and will no longer need to raise interest rates. With the economy likely to begin feeling the full effect of an over-5% jump in the Fed Funds Rate, inflation continuing to slow, and signs that higher yields are impacting borrowing, yields will likely be lower next year. Diversification remains prudent.. Please continue working with your financial professional to help you align your portfolio with your long-term investment objectives. Creating a financial plan that you can monitor and follow helps to avoid distractions and to stay focused on what you can control. ________________________________________________________________________________
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