Will Rising Yields Tank Stocks? Let's See How Story on Fed Is Shifting

What a difference a week makes. When I published my Federal Reserve meeting reaction, long-term bond yields were falling, continuing a narrative that perceived Fed hawkishness would wind up torpedoing the recovery. Just a few days later, and bond yields are surging, while the yield curve is steepening. So what caused the change of narrative? And how long will it last? Here is how I'm thinking about this and where I think it goes next. Is This 'the Breakout'? Will we look back at the September Federal Open Market Committee meeting as a major turning point for rates? Maybe, but I wouldn't jump to that conclusion. The catalyst for this violent move higher in the last few days appears to be more technical than fundamental. The 10-year Treasury futures contract crossed over some important moving average indicators last week, which appears to have caused some longs to exit and likely emboldened some shorts to get set. There was significant chatter that large futures traders were liquidating huge longs on Tuesday and reversed them into shorts. Now it could be that the same momentum-based model trading that pushed Treasury yields back into the 1.20's earlier this month are now going to push yields the other way. Unfortunately, this isn't the kind of clear fundamental catalyst that could really result in a breakout. To wit, markets have only added one Fed rate hike since Wednesday's FOMC (occurring sometime in 2023). It will take more than that for the 10-year to sustain above 1.60%. Now it could happen that the fundamentals catch up with the technicals so I'm not recommending getting long duration here. Just want to temper the excitement of those that have been waiting for higher yields. Will Rising Yields Tank Stocks? Certainly higher yields have seemed to shake up the stock market the last few days, culminating in the S&P 500 selling off 2% on Tuesday, with rate sensitive stocks leading the selloff. Now I'm not a stock guy, but maybe I can help frame this question for readers anyway. There are two reasons why stock investors might worry about interest rates. The first is that it raises the discount rate on future earnings. The other possible worry is that yields are rising, because markets think the Fed will be hiking rates, but that money is getting tight. Tight money tends to cause recessions and certainly risks that earnings growth becomes impaired, with more cyclical companies more vulnerable. Readers undoubtedly know how this last played out recently. For the last 12-months, interest rates have mostly moved with economic optimism. When it looks like growth (and hence inflation) might be stronger, yields have risen. Hence more cyclical stocks have tended to perform well on days when yields are rising. On the flip side, most fast growing companies aren't expected to have much earnings variance from cyclical improvement, so the discount rate factor dominates and these stocks tend to underperform when yields rise. All pretty straight forward so far. This simple story gets more complicated from here on. In the first quarter of 2021, yields were rising because inflation expectations were surging on positive growth vibes. Actual Fed rate hikes were a far off possibility. That's no longer true. If inflation pressure is seen as growing, markets will price in more rate hikes, and probably a quicker liftoff. Both greatly increase the chance that money will eventually get tight, which slows growth. We can see this in the shape of the yield curve. The chart below shows daily performance of the Russell 1000 Value less the Russell 1000 Growth from Sept. 30, 2020 to today (vertical axis) compared to either the change in the 10-year Treasury (blue dots) and the 5-year to 30-year curve slope change (red dots). Source: Bloomberg, Russell Indexes For small changes, these relationships aren't super strong, but for larger changes they certainly are. On days when the 10-year rose at least 5 basis points over this period, value beat growth 72% of the time. On days when the 10-year fell 5bps, growth outperformed 95% of the time. However. you also see that the curve steepening (i.e., the 5-30 slope increasing) is also associated with value performing. That's because higher yields plus a steeper curve indicates improved long-term growth prospects. Higher yields plus a flatter curve suggests money is tightening on the margins. When the yield curve flattens at least 3bps, value underperformed growth 65% of the time and lost money outright 62% of days. Now, to be fair, one could add a bunch of nuance into this argument, like pointing out that the Russell 1000 Value has a lot of financials that are directly tied to rates. Or that higher inflation is probably directly beneficial to real estate and energy, which is also heavy in the value indexes. I'll leave all that to the stock guys. I'm just saying that the playbook that worked in the fourth quarter of 2020 to the first quarter of 2021 period of rising yields won't necessarily work from here on. Yield Curve Steepens... The yield curve has steepened a little since the Fed meeting, with the 5-30 part of the curve widening by 10bps as of Wednesday morning since the FOMC. In my view, this is merely a reflection of the mass repositioning going on right now. The fundamentals actually support a curve flattener. The curve basically always steepens while the Fed is easing policy and flattens while it tightens. You can see this from the long-term chart below, with the circles representing local lows for the yield curve. Source: Bloomberg The impetus for a steepening curve earlier this yield was that the Fed was allowing inflation expectations to rise. Now that the Fed has defined their tolerance level for inflation, there is very limited scope for inflation expectations to rise meaningfully. That takes out the most common impetus for a higher and steeper yield curve. The other possibility is that real yields would rise in the long end on economic optimism. By real yields we mean the yield that is left over after accounting for expected future inflation. However for this to steepen the curve, it would have to happen independent of higher Fed rate hike expectations. Or put another way, there would have to be stronger growth without eliciting more rate hikes. I struggle to see how that comes about. What About Expected Inflation? Last week veteran Fed research economist Jeremey Rudd published a paper with the very click-bait title of Why Do We Think That Inflation Expectations Matter for Inflation? (And Should We?). The paper pulls no punches, so if you aren't afraid of some technical economics and enjoy seeing an academic go scorched earth on his own profession, have a read. I only bring it up here because this question of how inflation expectations influence actual inflation will be critical for how central banks around the world act in the next few years. All of the most hawkish FOMC members love to cite the danger that inflation expectations get out of control and force the Fed to act aggressively. Whereas doves are fond of reminding us how grounded expectations are, and therefore how challenging it will be to raise inflation even a small amount going forward. This is a debate investors would do well to watch carefully. Shake up at the Fed Lastly, and speaking of hawks, there was news this week that two FOMC members would be stepping down from their posts: Dallas Fed President Robert Kaplan and Boston Fed President Eric Rosengren. Both were caught up in the recent personal trading scandal, so the timing is undoubtedly related to that, although in fairness, Rosengren has serious health issues. These were two of the most hawkish voices on the FOMC, so their departure could shake up the dot plot for December. Both men are being replaced by the first vice president of each bank, which in both cases is someone with a banking and regulatory background, not a monetary economist. Hence, there is a good chance their dots will be a function of what information is being supplied by their research staff. Basically we're going to find out if either Kaplan or Rosengren were overriding their own staff with their hawkish stances. Regardless, I don't think having two strong hawks leave the FOMC matters much for the actual path of interest rates. The Fed isn't a democracy. It is dominated by the Chair. Everyone on the FOMC is really just vying for influence. I don't know how influential Kaplan or Rosengren were, but I doubt it mattered much outside of maybe some wording changes here and there on the post-meeting statement. Rate hikes are going to happen on Chair Jerome Powell's terms so long as he's the person in charge.

Will Rising Yields Tank Stocks? Let's See How Story on Fed Is Shifting

Bond yields are surging, the yield curve is steepening, and Dallas Fed's Robert Kaplan and Boston's Eric Rosengren are exiting. Here's my take on what's happening.

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