Bond Selloff Prompts Rethink by Stock Investors
If yields rise more quickly and unpredictably than expected, that would be disruptive to assets like shares, many analysts say
The sharp increase this month in U.S. government-bond yields is sending tremors through stocks, weighing on hot technology shares and some other sectors while prompting a deeper reassessment of the threat posed by rising interest rates.
For now, many investors remain optimistic because the reasons behind the bond retrenchment are mostly positive. Stuck near historic lows for most of last year, Treasury yields have climbed in recent months along with investors’ expectations for a strong economic rebound, driven in part by more debt-financed government spending.
Rising yields, which result from falling bond prices, often reflect investors’ expectations of faster growth and an accompanying rise in inflation, which erodes the purchasing power of bonds’ fixed payments and can eventually lead the Federal Reserve to raise short-term interest rates. More government borrowing also can boost yields by increasing the supply of bonds. Though many investors are keeping an eye on inflation data, analysts and portfolio managers say so far there is little reason to believe price levels will rise enough to prompt the Fed to raise rates any time soon, which looms as perhaps the greatest risk to major stock indexes.
“The market has principally been saying, ‘Hooray, the pandemic is coming under control and the economy is starting to grow again,’” said Brad McMillan, chief investment officer at Commonwealth Financial Network, an investment adviser and brokerage firm. “But now we’re actually starting to see the consequences of that in the form of higher rates, and I think the market’s processing that.”
As of Friday, the yield on the benchmark 10-year U.S. Treasury note stood at 1.344%, up from 1.157% just five trading sessions earlier and roughly 0.9% at the start of the year.
Treasury yields got a big lift in the fall when Pfizer Inc. announced promising results from its coronavirus-vaccine trial, and in early January when Democrats won two pivotal Senate elections, opening the door to trillions of dollars in government spending.
The move over the past week caught investors’ attention because no specific catalyst was apparent. That raised the prospect that yields could rise more quickly and unpredictably than expected—an outcome that many believe would be more disruptive to other assets such as stocks than a slow, orderly climb.
The S&P 500 fell 0.7% for the week, dragged down largely by technology stocks, which after big gains in recent years are seen as especially vulnerable to rising yields. Banks, meanwhile, rose as investors bet that higher long-term interest rates and an improving economy would boost profitability.
Investors this week will monitor the latest developments in Washington, where House Democrats hope to finalize a $1.9 trillion stimulus package, as well as figures on consumer spending and earnings from consumer companies such as Home Depot Inc. HD -1.20% and Macy’s Inc. M 4.54%
They will also keep watching Treasury yields, whose rise can hurt stocks in a few different ways, according to investors and analysts.
As yields move up, borrowing costs for most businesses should also rise, crimping profits. Higher yields could also attract to bonds some investors who were previously invested in stocks because they felt they had no other alternative to earn a meaningful return.
Finally, many investors use the 10-year Treasury yield as a discount rate in formulas to value stocks. All else equal, the expected cash flows of companies are considered less valuable when yields are higher. That poses a threat to many tech stocks because much of their earnings are expected to come further in the future.
Treasury yields remain extremely low by historical standards, but they aren’t so low relative to stock prices, some argue. In recent years, the 12-month forward-earnings yield of world technology companies—their expected earnings per share as a percentage of their stock price—has generally exceeded the 10-year Treasury yield by at least 2.5 percentage points.
But the yield differential has recently fallen below that threshold—one sign that the stock-market rally that was previously justified by ultralow bond yields “is turning irrational,” Dhaval Joshi, chief European investment strategist at BCA Research, a Montreal-based investment research firm, wrote in a report last week.
Still, many investors aren’t too worried about rising yields, seeing them mostly as a welcome sign that the economic outlook is improving.
“Our base case is for the positives of a higher rate regime to outweigh the negatives,” said Matt Peron, director of research at Janus Henderson Investors. Most professional stock investors have already baked higher yields into their valuation models, and the largest tech companies generally have earnings that justify their prices, he added.
Even so, rising yields could cause investors to rethink their allocations to different sectors, Mr. Peron said. His own team started adding exposure in the second half of last year to companies such as certain retail brands and online travel businesses that stand to benefit from an economic recovery and are less vulnerable to rising rates.
Of course, the threat to stocks from the bond market depends a lot on how high and how quickly yields can rise, analysts said. Many analysts forecast that the 10-year Treasury yield will reach anywhere from 1.5% to 2% by the end of the year as investors start preparing for future rate increases from the Fed.
Still, there are factors that could cause a more disorderly selloff in the bond market.
Under a worst-case scenario for bonds, large amounts of government spending could start generating the type of inflation that at this point is only theoretical, investors and analysts said. That could intensify speculation about tighter monetary policies even as investors are forced to absorb larger quantities of new Treasury debt.
So far, though, rising yields reflect uncertainty about the future more than any tangible changes in the economy. Earlier this month, the Labor Department reported that core consumer prices, excluding the often volatile food and energy categories, were essentially flat for the previous two months.
Treasury yields fell at the time, only to begin their latest steep ascent just two days later.