A spike in long-term rates supports equities
The tech sector saved the day yesterday as the Nasdaq Composite dipped its big toe back into bearish territory for the year. Perhaps Twitter’s decision to accept Elon Musk’s $44 billion fed animal buyout offer minds, but I think it had more to do with historically bearish sentiment levels and valuations that are almost reasonable ahead of earnings reports from the top five large-cap tech names this week. Lower long-term interest rates have also been a key ingredient in the recovery, but not for the reasons one would hope.
The latest wave of Covid-19 in China has led to widespread shutdowns that have investors worried about a slowdown in the rate of global economic growth, which is one of the reasons the 10-year Treasury yield has fallen from a peak near 3% to 2.8%. At the same time, growth concerns are driving oil prices lower, with WTI crude falling below $100 a barrel yesterday. Yet this should also ease some inflation concerns, and falling long-term interest rates are providing some support for growth stock valuations. Moreover, the decline in rates has a historical precedent that has nothing to do with headwinds in the Chinese economy.
The rapid rise in long-term rates resulted in one of the worst quarters for the bond market in decades, with the 10-year yield jumping more than 150 basis points in the past six months alone. The Federal Reserve has been telegraphing ever since the start of the year in anticipation of monetary policy tightening. The investor consensus is that rates have nowhere to go but higher from here as the Fed needs to be way behind the curve to contain inflation, but if history repeats itself, it won’t. may not be the case after all.
There have been 10 periods in the past 20 years where the 10-year yield has risen by more than 1% over a similar duration, and what followed in the six months since was a drop in yield across all cases except one. I can see a similar result today, but not due to the latest wave of coronavirus in China.
Long-term rates are expected to stabilize or even decline over the next six months as the consensus among investors realizes that the inflation rate has peaked and the market has tightened too much in the expectation. Fed policy changes. As long-term inflation expectations ease, so should the expected rise in short-term interest rates. Both should support stock prices, provided corporate earnings meet expectations, which they are on track to do in the first quarter.
If long-term rates continue to rise, then we have a different story, as the growth stocks that hold the largest weightings in the major market averages could drag the S&P 500 into bearish territory, which we barely have. Avoided in 2018. It’s not my expectation today, but it is a concern. Reports on this week’s results should be crucial.
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