Stock investors who sleepwalked to an $8 trillion rally earlier in the year are being shaken awake by the bond market.
(Bloomberg) — Stock investors who sleepwalked to an $8 trillion rally earlier in the year are being shaken awake by the bond market.
Worrying signals on everything from inflation, government deficits, valuations and, arguably, the nearness of a recession proved too much for the equity faithful to withstand this week, torpedoing the S&P 500’s October advance and pushing losses since July to almost 7%.
Bulls find themselves with fewer reasons to buy and plenty to sell. Inflation expectations have quietly jumped in bonds where yields underpin an increasingly persuasive valuation case against stocks. Treasury price action has shifted to a so-called “bear steepening,” with gains in long rates outpacing those in shorter ones, a harbinger of past gloom.
Meanwhile, Federal Reserve Chair Jerome Powell seems to have finally convinced traders that however bad things get, he has no plans to cut rates anytime soon. The weight of those worries dragged the S&P 500 lower by 2.4% this week, putting the index on track for a third straight month of losses, a streak that last occurred at the onset of the 2020 pandemic.
“We’ve seen bond rates increase over the last few months and stocks, all of them, are long-duration assets, and they can only take so much increase in real interest rates before they begin to soften,” said Ellen Hazen, chief market strategist and portfolio manager at F.L. Putnam Investment Management. “The risk was there and we’re beginning to see that realized.”
Benchmark 10-year Treasury yields soared 30 basis points this week, taking the rate within a whisker of 5% for the first time in more than 16 years. By contrast, yields on two-year Treasuries — the tenor most sensitive to monetary policy expectations — rose just 2 basis points. That dynamic sent the 2- to 10-year yield curve to just negative 17 basis points, the least inverted level in over a year. Commodities only added to the drama, with oil and gold notching a second straight week of gains.
Powell spoke Thursday and was emphatic that relief in the form of rate cuts isn’t in the cards. While inclined to hold policy steady at its next meeting, the Fed chief suggested that another hike may be warranted should policymakers see further signs of resilient economic growth, adding that inflation is still “too high.”
“The reality that has begun to sink in over the past month since the FOMC meeting is that the Fed is not cutting rates back to pre-pandemic levels when inflation cools. Rates will settle back in at higher level,” said Michael O’Rourke, chief market strategist at JonesTrading. “That means that the discount rate one uses for investment-valuation models needs to be higher, which means multiples contract and valuations come down.”
Recent price action hints there could be more work ahead for the Fed. Breakeven rates — a bond-market measure of inflation expectations, have climbed in recent weeks, breaking out of a well-defined range. They join a months-long march higher in so-called real rates — a measure that strips out the impact of inflation — which are hovering near decade-plus highs.
The resulting surge in nominal Treasury yields has created a worthy competitor for risk assets. Profits in the S&P 500 are currently about 4.8% of the index’s price, meaning that Treasuries across the curve out-earn equities at the moment. That’s sent billions of dollars barreling toward bond funds all year, with investors eager to lock-in lofty yields.
“There’s a point at which there’s an alternative to equities and we’re in that world now,” said Art Hogan, chief market strategist at B. Riley Wealth. “It’s clear that if you’re looking for yield, you’re going to find it in a much safer place in US Treasuries.”
The Treasury curve shifting this week was another concern for equity bulls. While a different pattern — the “bull steepening” — is more commonly trotted out as a worrisome portent, the bearish version doesn’t bode well for traders either.
High-inflationary episodes prior to 1991 provide a reasonable blueprint for today, according to Barclays. Should the current curve-steepening episode follow that script, it would spell bad news for stocks as the Fed holds rates steady and long-end yields rise, pressuring cash flows and equity valuations.
“Bear steepening out of inversion seems to break from tradition in terms of yield-curve recession signals of the recent past,” strategists led by Venu Krishna wrote in a report this month. “However, looking further back to prior high-inflationary periods suggests that we have traveled this road before, which would leave equities few opportunities to escape unscathed.”
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