Will Rising Yields End the Party?
Ben Levisohn of the WSJ reports, Rising Yields Could End the Party:
corporate profits rising and economic data coming in better than
expected lately, stocks are surging. But so are bond yields—and that
could spoil the party.
Bond yields and stock prices have been
rising together. On Feb. 8, the Dow Jones Industrial Average touched
12233, its highest level since June 2008. The same day, the yield on
the 10-year Treasury reached 3.72%, the highest since April 2010. Rates
have risen for six consecutive months, the longest such streak since
Signs of a healthier economy are growing more numerous by
the day. The Chicago Purchasing Managers Index, for instance, rose in
January to its highest level since 1988. Corporate profits also have
been better than expected; more than 70% of the companies in the
Standard & Poor's 500-stock index that have reported fourth-quarter
results so far have beaten earnings projections.
rising bond yields can cause problems of their own. Higher yields
raise borrowing costs for companies, homeowners and municipalities,
especially overleveraged ones. Over time, those higher costs can be a
drag on corporate profits and economic growth. Rising yields also make
bonds relatively more attractive than stocks for income-oriented
The question for investors is when bond
yields and stock prices might start to decouple. Since 1963, stocks and
bonds have tended to move in opposite directions whenever the yield on
the 10-year Treasury note has risen above 5%, according to data
compiled by LPL Financial in Boston. When the 10-year yield is below
5%, stocks and yields tend to move in the same direction.
recently, however, 4% yields have been a pivot point—and given the
surge in yields recently, that is reason for caution. On April 5, for
instance, the 10-year Treasury yield briefly rose above 4% as investors
worried that the Federal Reserve would have to raise rates to tamp
down inflation. During the next two months, the S&P 500 fell 12%,
as U.S. economic data soured and the "flash crash" spooked investors.
we get to 4% and it's purely a market move, then we have a problem,"
says David Ader, head of government-bond strategy at CRT Capital Group
LLC in Stamford, Conn.
If rates rise too quickly in coming
months, that could undermine any budding recovery in housing and
municipal finance, says David Bianco, chief U.S. equity strategist for
Bank of America Merrill Lynch. That is because mortgage rates and
municipal bond yields both track Treasurys to some extent, and an
increase in borrowing costs could add further stress to these fragile
areas of the economy.
Mr. Bianco says a move to 4% or higher
during the first half of 2010, or above 4.5% during the second half,
could exacerbate problems.
above 4% characteristically doesn't trigger an economic slowdown or
recession," adds James Stack, president of InvesTech Research in
Whitefish, Mont. But "it will provide a headwind."
come under pressure, too, if the gap shrinks between the 10-year yield
and the overall stock market's "earnings yield," a measure of a
company's earnings per share as a percentage of its stock price that is
calculated by taking the reciprocal of the market's price/earnings
ratio. When the difference between the 10-year yield and the earnings
yield drops below zero, it can signal a shift in the market, as it did
in mid-2008, before the market plunged and Treasurys soared.
Conversely, the ratio crossed zero into positive territory in 2004, and
stocks rallied for three more years.
now, the market trades at about 17.2 times trailing 12 month earnings,
according to Ned Davis Research in Venice, Fla. That translates to an
earnings yield of 5.82%. With the 10-year yield at about 3.65% now, the
difference is about 2.2 percentage points—much less than the August
peak of 3.7 percentage points. And with bond yields expected to
continue their rise and earnings yields to fall, it may be only a
matter of a few months before the difference disappears, says Tim
Hayes, chief investment strategist at Ned Davis.
are emerging that bond yields and stocks are poised to go their
separate ways. On Feb. 3, the one-year correlation between the two
measurements fell to 0.43, down from nearly 0.6 in September. (A
correlation of 1.0 means two indices move in lockstep; a correlation of
minus-1.0 means they move in complete opposition.) That was the weakest
correlation since the beginning of 2010.
course, this doesn't mean investors should run for the exits. Yields
remain at levels that likely signal optimism about growth rather than
fears of inflation. But rising yields do mean investors should exercise
caution. If yields continue to rise, they should look to more
defensive sectors, including energy and staples, Mr. Hayes says.
question is how much higher rates will the market tolerate," he says.
"More often than not, rising rates ultimately become a problem for
I like Tim Hayes and Ned Davis Research and
pay attention to what their models are forewarning. Another independent
research firm, BCA Research, has been warning government bond buyers to beware:
recent breakout of the U.S. 10-year Treasury yield above 3.5% is an
important technical signal, highlighting that the macro-backdrop is
increasingly turning against the bond market," said BCA Research in a recent report.
global cyclical bond indicators have been bearish for some time and
valuation is poor in most of the major countries. The only missing
ingredient for a fully-fledged bond bear market is the start of
monetary tightening cycles in the U.S. or Europe. Recent comments from
Chairman Bernanke, President Trichet and Governor King give us little
reason to question our call that the Fed, ECB and BoE are on hold
until early 2012. Nonetheless, there is room for the market to
discount a faster pace of rate normalization even if central banks do
not get started until early next year."
are not extremely bearish on government bonds in the near term
because the absence of central bank rate hikes should limit the upside
for yields in the coming months. Nonetheless, we expect yields to
ultimately be significantly higher on a 6-24 month horizon."
the bond market kill the party in equities? That depends on inflation
expectations and the US jobs market. So far, the latter hasn't shown any
signs of a sustained pickup but inflation pressures are building,
especially in emerging markets. In fact, the ECB chief recently warned
that rising food demand could drive inflation:
Central Bank head Jean-Claude Trichet said Wednesday that food prices
could keep rising due to increasing demand from emerging countries and
suggested a global effort to raise production in Africa.
consumption patterns in large emerging countries have fuelled food
prices and “it is quite possible that this will continue for a while
longer,” Trichet told the German weekly Die Zeit in an interview.
the same time, there are huge expanses of land in Africa which could
be used for agricultural purposes,” Trichet added. “We need to provide
the right incentives for African farmers in this respect.”
called the situation “an important global issue which should be taken
up by bodies such as the G20” group of developed and emerging
Higher prices would not force the ECB to raise
interest rates but the bank would focus on avoiding “second-round
effects” whereby high oil and food prices are transformed into
It would watch in particular for signs of “a wage-price spiral,” Trichet said.
where economic activity is pushing inflation to levels that have begun
to ring alarms, as is the case in Germany, should adopt “more
restrictive” policies “to avoid the economy overheating or speculation
getting out of control,” Trichet said. He noted that “Germany has also
succeeded remarkably well in regaining its competitiveness over the last
10 years (and was) ... now reaping the rewards of its patient
But the ECB president
cautioned that German output had not yet returned to levels seen
before the global financial and economic crises.
downplayed notions that some Germans were becoming more sceptical of
the 17-nation eurozone because they might have to provide substantial
financial support for weaker members in the coming years. “Deep down,
everybody is aware of the importance of our historic project,” he said.
though global inflation is on the rise, the WSJ reports that traders of
U.S. federal-funds futures seemed to have less faith that price
pressures will force the Federal Reserve to begin lifting its key short-term rate by the end of this year:
central bank's funds rate target has remained inside a lowest-ever
range of 0% to 0.25% since December 2008, but the market had recently
forecast a higher rate by year's end after some encouraging economic
data and inflation worries.
However, Federal Reserve Bank of
Chicago President Charles Evans--a voting member of the rate-setting
Federal Open Market Committee--said Thursday that unemployment is still
too high and overall inflation to low for the Fed start raising rates.
Evans and other Fed officials this week signaled that the
central bank will likely complete its current quantitative easing
program as scheduled at the end of June. The program, also known as
QE2, refers to the Fed's purchase of $600 billion in U.S. Treasurys to
keep longer-term rates low and help speed up the economic recovery.
Evans explained that recent food and energy price increases account for only a small percentage of overall inflation.
Outside the U.S., inflation appears to be a bigger worry, which is
primarily responsible for Friday's steepening of the yield curve.
A steeper curve means the market anticipates longer-term rates rising while shorter-term rates stay low.
European Central Bank Executive Board member Lorenzo Bini Smaghi
warned that the ECB may have to raise rates if global inflation
"It is a key challenge for monetary policy
to avoid spillovers and maintain inflation expectations in check," said
Bini Smaghi in an interview published Friday in the daily newsletter
Bini Smaghi's comments came on the same day
that producer prices in Germany--Europe's largest economy--jumped 1.2%
in January and 5.7% on an annual basis. The annual figure was the
highest since October 2008.
Meanwhile, U.S. federal-funds and
the bulk of the most-actively traded Eurodollar futures contracts
priced in lower short-term rates on Friday, due in part to traders'
desire for safe investments ahead of the long holiday weekend.
Safe-haven bids were tied to continuing turmoil in the Middle East,
including citizen protests in several countries and escalating tensions
between Iran and Israel.
At Friday's settlement, January
2012 fed-funds futures--measuring expectations for the Dec. 13 FOMC
meeting--priced in a 54% chance for the committee to raise the funds
rate to 0.5%. That's down from a 64% chance at Thursday's settlement,
and a 94% chance at last Friday's settlement.
February 2012 fed-funds futures were no longer fully priced for the
first rate hike to occur at the Fed meeting in late January of next
The February 2012
contract priced in a 94% chance for a 0.5% rate, down from being fully
priced for the move on Thursday. A week ago, the same contract had also
priced in a 40% chance for a further tightening to 0.75%.
A 0.75% funds rate is no longer factored into the February 2012 contract.
Also, a large-volume options trade performed Friday signaled
expectations for a continued rally in prices--equal to lower implied
rates--for second year Eurodollar futures contracts.
reported a trading firm performed 30,000 to 40,000 spreads,
simultaneously buying and selling call options, aiming for June 2012
Eurodollar futures price to reach 99.125 before the calls expire in June
of this year.
99.125 strike or underlying futures price, June 2012 Eurodollars would
reflect expectations for the implied London interbank offered rate, or
Libor, to fall to 0.875%.
Libor expectations are calculated by subtracting the Eurodollar futures price from 100.
At Friday's settlement, June 2012 Eurodollar futures were 3.5 basis
points higher at 98.615, projecting Libor to reach 1.385%.
Eurodollar futures reflect market expectations for changes in the
three-month Libor, which is the rate that banks charge each other for
borrowing U.S. dollars.
The three-month dollar Libor is also
viewed as a benchmark for lending to businesses and households, and
it's frequently considered as a surrogate for U.S. fed-funds rate
Elsewhere, inflation pressures are
building and so are expectations of rate hikes. Unveiling the Bank of
England’s quarterly inflation report on Wednesday, Mervyn King, the
governor, bent over backwards to insist no decision had been made on
whether, or when, the monetary policy committee should raise interest rates:
aside from a few traders in the sterling currency markets, the
consensus remains that a signal on rates has been given and the next
move is likely to be as little as three months away.
February inflation report contained two important messages,” said Simon
Hayes, economist at Barclays Capital. “The first is that the MPC is
leaning towards a rate rise over the next few months. The second is that
the envisaged policy tightening is small and gradual and may yet be
subject to delay, depending on the evolution of the data.”
Mr Hayes’s comments were echoed by many other long-term MPC observers.
process by which economists have come to this conclusion is highly
technical. Malcolm Barr, economist at JPMorgan, says it requires
enlarging the Bank’s trademark fan chart showing the likely path of
inflation and applying a large ruler against it to measure changes.
reason economists have been reduced to reading the runes is Mr King’s
habitually circumspect presentation on the day of the inflation report.
Observers must wait for the monthly publication of the MPC minutes to
discover the numbers behind the Bank’s forecast.
On Wednesday he
said only that the Bank’s inflation forecast was “based on the
assumption that Bank rate follows a path implied by market rates...”
look at the interest rate futures market shows that in 12 months rates
are expected to be 1.358 per cent, implying three, quarter point rate
hikes by then. By August, the markets expect rates to be more than 1
per cent, suggesting two increases will have taken place by then.
King, however, went to great lengths to insist the MPC “does not
endorse the market path for interest rates”. “We never do,” he said.
What this tells me is that inflation pressures are building but it's too
early to call for rate hikes in the US. In Europe and England, rate
hikes are likely in the next few months, but expect a gradual approach
if they start hiking rates.
And what about the stock market? Will the bond market kill the party in
stocks? Isn't that always the case? This typically is the case, but
it's not that simple. Even if central banks start hiking rates, there is
so much liquidity in the global financial system that stocks will
continue grinding higher and in some sectors, another bubble is already underway.
In other words, rising yields will not end the party anytime soon but
they will put pressure on stocks and force asset allocators to rethink
their asset allocation.
But for now, I wouldn't be too concerned about rising bond yields. And don't forget, despite what some smart economists are writing, deflation isn't dead. Fairfax Financial, one of the best funds in the world, is still positioned for deflation
with 89% of its equity exposure hedged through total return swaps on
the Russell 2000 and S&P 500. They took a hit last quarter but might
eventually turn out to be right with this deflationary macro call. If
deflation fears reappear, funds should be preparing by scooping up
government bonds as yields rise. Deflation might turn out to be the
surprising call of the next decade.