Treasury Yields on the Rise Again

Introduction

Treasury yields are once again on the rise, with the 10-year yield surpassing 4.3%. This upward trend indicates the highest point since late 2007. While this may seem like good news for bondholders, it poses a problem for the stock market. Higher interest rates on secure bonds reduce the potential returns on riskier assets like stocks, making them less appealing to investors. Given the current high valuation of the S&P 500 and the prevailing market volatility in 2023, this situation compounds the challenges facing the stock market.

The Continuing Rise of Yields

Despite hopes for a reversal, there seems to be no immediate end in sight for the upward trajectory of yields. Last month's hawkish notes from the Federal Open Market Committee (FOMC) meeting contradict Wall Street's anticipations that interest rate hikes are a thing of the past for this cycle. Benjamin Jeffery, BMO Capital Markets' Vice President of Rates Strategy, emphasizes that monitoring the 10-year yields is crucial, particularly the support level at 4.335%, representing the peak yield mark from October last year.

Historical Context

While high yields are concerning for stocks, it's important to consider the broader context. The current levels haven't been witnessed since the Great Financial Crisis; however, over the past decade and a half, interest rates have been abnormally low. In fact, historical data shows that payouts on the 10-year T-note have exceeded the present levels in the pre-crisis period. This indicates that there are various reasons why Treasury yields should be higher, and they don't always have a negative impact on stocks.

The Wrong Reasons

Notably, experts like Dennis DeBusschere, President and Chief Market Strategist at 22V Research, caution against dismissing this upward trend in yields as normal market forces. They argue that the driving forces behind this increase, such as weakening economic growth and growing Treasury supply, are not desirable. It's essential to recognize the underlying factors at play, which might have potentially adverse effects on the economy.

In conclusion, Treasury yields are steadily rising, affecting the stock market negatively. Although this development might be justified in certain contexts, caution is warranted due to the underlying reasons behind these increased yields. Vigilance and a comprehensive understanding of the situation are crucial as investors navigate these uncertain times.

The Potential Challenge of Inflation and Interest Rates

Given the steady state of the economy and wages, it appears unlikely that inflation will significantly decrease in the near future. This suggests an increased risk that financial conditions will need to tighten, potentially leading to higher interest rate hikes. These hikes can be troublesome for risk-on asset classes and have the potential to push yields higher. It may seem contradictory, but in order for a broad risk-on rally to take hold, economic growth needs to slow down to some extent.

Real Rates Pointing Towards Higher Yields

Nicholas Colas, co-founder of DataTrek Research, argues that real rates, which do not consider the impact of inflation, are also indicating a rise in yields. Unlike October of last year, when we saw 10-year T-notes reach their peak in the previous cycle, inflation expectations are currently holding steady at around 2.3%. By looking back at the pre-crisis period, one can observe real rates trading between 2% and 2.7%. With present real rates approaching 2%, Colas suggests that we could be on track for a return to that range.

A Long-Term Rate Shock and its Impact on Equity Markets

Colas continues to predict that 10-year yields could reach approximately 4.5%. He believes that the current slow-motion long-term rate shock still has a way to go and expects equity markets to face challenges as it unfolds. This aligns with his belief that the coming weeks may be marked by uncertainty and volatility.

Considering these factors, it seems that we may be in for a challenging end to the summer.