U.S. bond yields began to rise last week as investor confidence in the economic recovery increased. The problem is that the stock market may not be ready for rising yields.
In less than two weeks, U.S. Treasury yields have risen sharply, with the 10-year and 30-year yields rising 20 basis points and 22 basis points, respectively. As of last Friday, the 10-year U.S. Treasury yield rose to 1.1% from 0.91% last Monday.
This indicator will have some impact on the aftermarket of U.S. stocks. Last year, the Federal Reserve announced a rate cut that sharply depressed yields, boosting market sentiment and spurring U.S. stocks to the upside.
But now, the Fed is threatening to let yields climb higher for now, meaning the current upward momentum in U.S. bond yields could continue. In such a scenario, the relative attractiveness of equities and risky assets would diminish, thus discouraging capital flows into equities and other risky assets.
In addition, rising U.S. bond yields could cloud the outlook for economic recovery, as this would potentially impact interest rate sensitive sectors such as the real estate sector.
Drivers Driving Yields Higher
So, what are the drivers of higher U.S. bond yields?
Some point to the Fed’s recent stance, which has raised concerns about the start of a rate hike cycle, as a driver of rising yields.
Analyst El-Erian, however, denied this claim, pointing out that the recent trend in U.S. Treasury yields does not reflect any substantial change in the Fed’s accommodative monetary policy stance. Moreover, the Fed reiterated in the minutes of its December monetary policy meeting released last week that it will not scale back its monetary easing program in the near term, and even if it does, the process will be gradual. If possible, the Fed will expand its balance sheet without limit to reinforce to the public the notion that there is a stable and reliable non-commercial buyer of Treasuries.
Is it the hope of economic recovery that is pushing up U.S. bond yields?
With the Democrats winning control of the Senate, the likelihood of Congress approving at least a few hundred billion dollars of additional fiscal stimulus to boost the economy has increased, but El-Erian believes that the fiscal stimulus aspect may not immediately have a significant impact on yields, considering that the Fed has not only committed to maintaining its massive asset purchase program, but has not even ruled out expanding its bond purchases in the future, or shifting more asset purchases to longer-term securities.
Meanwhile, the outlook for economic growth has deteriorated under the shadow of the recent surge in the number of infections, confirmed cases and deaths regarding the new crown outbreak. The U.S. monthly employment report released on Friday showed that employment fell by 140,000 in December.
As a result, the outlook for the economic recovery remains fraught with uncertainty. As for other factors that are likely to drive U.S. bond yields higher, such as the increased risk of government default, El-Erian believes the argument is even more nonsensical.
The most likely driver, according to El-Erian, is the expectation of rising inflation, as evidenced by higher inflation break-even rates and other inflation-sensitive market segment movements.
In addition, investors’ hesitation to buy U.S. Treasuries may also lead to higher U.S. bond yields. Because U.S. Treasuries are no longer an ideal asset choice for risk reduction under the weight of Federal Reserve policy, reduced buying could lead to lower prices and higher yields.
The impact of soaring yields on the market
Why has the rise in U.S. bond yields become a signal to be wary of? Exactly what impact does it have on the market?
Analyst Jacob Sonenshine says a gradual rise in U.S. bond yields is usually seen as a sign of optimism, but a sudden spike in yields or a price not yet reflected in the market could become a problem for the stock market. The average price-to-earnings ratio for S&P 500 constituents is slightly below expectations at 23 times and well above the long-term average price-to-earnings ratio of about 15 times. This suggests that stocks are currently overvalued in a low interest rate environment.
Albert Edwards, global strategist at Societe Generale, writes that.
“Even though the 10-year U.S. Treasury yield is currently only slightly above 1%, it is enough to reach the tipping point that would burst the stock market bubble.”
Some analysts, however, are not convinced. For example, analyst Jacob Sonenshine believes that the current valuation of U.S. stocks has not yet reached the level that would make the bubble burst. At current prices, the average yield on stocks in the S&P 500, minus the yield investors can get by holding safe 10-year Treasuries, is 3.27%, and the equity risk premium usually hovers above 3%, so this suggests that valuations are not out of control yet.
But it’s important to note that the equity risk premium rarely falls below 3 percent, and when it does, stocks tend to fall. edwards said in his report that the data suggest bond yields will rise sharply, which would mean a lower risk premium if equity yields did not rise accordingly.
Edwards said the 10-year U.S. Treasury yield tends to move up and down with the U.S. Supply Management Council’s (ISM) Purchasing Managers’ Index (PMI), which recently reached about 60 percent, its highest level since 1995, and is associated with a rise in the 10-year Treasury yield of more than 1.1 percent (the PMI usually uses 50 percent as the economic strength cut-off point: when the index is above 50%, it is considered an economic expansion, while when it is below 50%, especially very close to 40%, it is considered a recession).
Jacob Sonenshine said that if yields spike quickly without the corresponding rise in PMIs and earnings growth from a recovering economy to support them, stock valuations will fall. Therefore, investors need to keep an eye on yield movements next.
In addition, if the volatility of U.S. Treasury yields increases in the coming weeks, it will worry policymakers and market risk takers. Analyst El-Erian believes that while the Fed wants higher levels of inflation, it does not want “stagflation” to occur. This is a nightmare existence, when the Fed has few tools to guide the economy out of “stagflation”. Stagflation coupled with sluggish economic growth will hit corporate profitability and will make the disconnect between financial valuations and fundamentals more severe.
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