Of all the defenses of the stock rally, the pitch on Wall Street that elevated bond yields are completing the Federal Reserve’s hawkish mission sounds the most dangerous.
(Bloomberg) — Of all the defenses of the stock rally, the pitch on Wall Street that elevated bond yields are completing the Federal Reserve’s hawkish mission sounds the most dangerous.
Even as the Middle East conflict escalates, the S&P 500 just notched a second straight weekly advance. One reason: A perceived social contract is forming between Jerome Powell & co. and traders. It says Treasury yields at lofty highs are tightening financial conditions enough that no more central bank action is needed — freeing equities of restraints that have bound them for two years.
The view is too clever for its own good, says the likes of Mizuho International Plc’s Peter Chatwell. Put simply, a world of 5% Treasury yields continues to threaten stock valuations and ramps up competition for risk capital.
“This is a major inconsistency in the market right now,” he says. “Sentiment in equities is listening mainly to what this means for the Fed funds rate, but bond yields are going higher, becoming more attractive relative to equity earnings yields, and forward earnings are being discounted by higher long-term rates.”
Extreme Treasury volatility remains the biggest story in financial markets. But even fresh swings in the world’s most important asset couldn’t hold stocks back — once again. On the anniversary of its bear-market bottom, the S&P 500 remains up more than 20% from that low, and the Nasdaq 100 higher by twice that.
The financial conditions hypothesis was buttressed by a parade of Fed speakers speculating about high yields doing the central bank’s job for them, even as they warned that the rate of inflation remains too high. Dallas Fed President Lorie Logan said the recent surge in long-term rates may mean less need for additional hikes. Vice Chair Philip Jefferson on Monday said he is watching the increase in Treasury yields as a potential further restraint on the economy.
That commentary helped arrest a five-week jump in 10-year yields and has coincided with a rush into exchange-traded funds tracking Treasuries that has seen nearly $7 billion poured so far this month. While those flows can be read as bets rates will fall, they also highlight a risk for the stock market — that the attractiveness of yield-bearing assets is growing.
“High bond yields all else being equal are both competition for stocks — e.g., investors are more inclined to put money in ‘safe’ Treasuries earning a guaranteed 5.5% versus, an uncertain return for stocks — as well as the mechanism by which all financial investments are determined,” said Chris Zaccarelli, chief investment officer at Independent Advisor Alliance.
As rates rise, certain valuation arguments for equities worsen. At present, 10-year Treasuries yielding about the same as the S&P 500 is providing in earnings, based on next year’s analyst profit estimate of $242.50 a share. That’s a big switch in favor of bonds, whose payouts had trailed stock earnings income by much larger margins for most of the last 20 years.
“Over the past two decades the S&P 500 earnings yield has on average been 3% higher the 10-year Treasury yield,” said Michael O’Rourke, chief market strategist at JonesTrading. “If Treasury yields remain constant, then equities need to move lower to move towards that historic risk premium. This is the more likely scenario.”
To be clear, restrictive monetary policy has been tightening financial conditions lately. A Goldman Sachs Group Inc. index of cross-asset health was pushed this month to the most sluggish level of the year. But while this gives central bankers less reason for hawkish policy decisions, it’s also a sign that the economic outlook is teetering.
Small businesses have been growing more pessimistic on the economic outlook and the availability of credit. Corporate bankruptcy filing activity has risen sharply this year while US consumers views of their finances is quickly deteriorating.
“There’s still a potential that these cumulative rate hikes have a sharper contraction on consumer and business activities,” said Tom Hainlin, national investment strategist at US Bank Wealth Management.
Michael Shaoul isn’t a bear on equities, at least not yet. Companies are generating a lot of earnings, aren’t excessively valued, and are owned by people who have shown themselves inured to most longer-term threats. What he doesn’t buy is the notion that rising long-term yields bespeak harmony in the economy in the long haul as the US government’s free-spending ways become a bigger risk to stability.
With the Fed likely on hold or close to it, “the great uncertainty is what happens at the long end of the curve,” said the chief executive officer of Marketfield Asset Management.
–With assistance from Emily Graffeo.
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