PMC Weekly Review – October 19, 2018

A Macro View: Is Winter Coming for the Bull Market? – Analyzing the Spike in Treasury Yields that Shook the Market

October has stayed true to the historical trend of being the most volatile month for stocks, with choppiness creeping in, the equity market tanking, and the S&P 500 Index dropping by more than 3% last Wednesday, October 10. The sudden spike in the longer end of the curve beginning mid-September is one of the reasons cited for this huge sell off. The yield on the 10-year Treasury Note recently soared to a high of 3.23%, a level not reached since July 2011. However, despite this steep increase, the yield is still much lower than historical norms, though the rate at which it has spiked has concerned investors.

Though several reasons can explain the abrupt spike in yields, a major cause is the positive sentiment in the economy, backed by strong economic numbers. During the first week of October, the Institute of Supply Management (ISM) published its nonmanufacturing data. The figures not only beat analysts’ expectations, but also recorded the ISM’s second-highest reading in history. Positive developments in the labor market also contributed, as the unemployment rate is at a fifty-year low, and the increase in the year-over-year average hourly wage growth is at its highest level since the 2008 financial crisis. As inflationary pressures creep in and the economy continues its robust pace, bond market participants believe that these figures will be paramount in driving the Fed’s future policy decisions.

The impact of this spike in yields on the economy bears watching. The increase in long-term Treasury yields will directly influence fixed-rate mortgages, forcing new homebuyers to shell out more to finance their purchase. Interestingly, 30-year mortgages hit a seven-year high of 4.9% in the second week of October. If yields continue to rise, investors may begin to pull out money from riskier assets, like equities, and rotate it into less risky, decently yielding instruments, such as Treasurys. However, stocks could be stuck in a seesaw battle between a booming economy (bolstered by strong consumer spending, record low unemployment, and corporate tax cuts), and deriving competitive yields (at much less risk) from another traditional asset class. The rising bond yields also make the stocks in the Utilities and Real Estate sectors (REITs are a traditional income generating vehicle), less appealing, as companies in these sectors extensively use leverage as a source of finance. An increase in yields would compel these firms to finance their debt at a higher interest cost, leading to earnings erosion. Additionally, valuations could be adversely affected by rising yields, as stocks would be discounted at a higher rate, which could compress cash flows.

Some market experts believe that it is not the spike in the yields, but rather the rate of change that should alarm investors. A Goldman Sachs study reveals that stocks in the S&P 500 Index cannot factor in a swift rise in bond yields, but markets can handle monthly yield moves that are within one standard deviation. This creates an interesting point: The recent movement in the long-dated bond yields is nearly two standard deviations, and could signal a more damaging effect to the S&P 500 Index’s P/E multiple. However, organically driven, rising corporate earnings and a strong economy have largely supported the equity market. Though the relationships between the two asset classes have varied over time, on a historical basis, whenever yields have been less than 5%, stocks and yield movements have been positively correlated.

Different bond pundits have made varying statements regarding the surge in yields. Rick Rieder, who oversees roughly $1.85 trillion in bond assets for Blackrock, the world’s largest money manager, believes that the recent spike in bond yields will not be sustained. He also maintains a contrarian view that the Fed will hike rates once or twice in 2019. On the other hand, Doubline Capital’s Jeffrey Gundlach says that he will not be surprised if the yield on the 30-year US Treasury Bond rises above 4%. He predicts the curve will steepen, which eventually will result in the yield on the 10-year US Treasury Note hovering around 3.5% to 3.6%. Bill Gross, of Janus Capital, has cited the absence of foreign buyers as the catalyst for the recent spike in yields.

However, it seems that there is no respite in the factors driving the increase in yields. Federal Reserve (the Fed) Chairman Powell clearly indicated in his recent statement that the central bank is a ‘long way’ from getting rates to neutral. This signals that it would be farfetched for the Fed to adopt an accommodative policy, and therefore it would continue to raise rates at regular intervals. This means that as the economy gains steam, the end investor can expect an end to the nearly decade-long era of low borrowing costs.

As such, market developments continue to occur, investors must ponder whether rising yields will mark the end of the prolonged bull market.


Suresh Ramasamy and Alfie Manuel

Investment Analysts

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