Rising Yields Pose a Challenge for Stocks

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The stock market is facing a formidable adversary – rising bond yields. For the first time in fifteen years, bonds are providing real competition to stocks. With the yield on the 10-year U.S. Treasury note reaching 4.25%, a 0.3-point increase since the beginning of August and close to its highest level since 2007, bonds are proving to be an enticing alternative, particularly as stocks appear overvalued.

This has resulted in a significant impact on the market. Last week, the Dow Jones Industrial Average fell by 2.2%, the S&P 500 lost 2.1%, and the Nasdaq Composite dropped by 2.6%.

The rise in yields can be attributed to a combination of factors. Some are primarily technical, such as higher U.S. Treasury issuance this month, the Bank of Japan allowing yields to drift higher, and credit-ratings firm Fitch downgrading the U.S. sovereign rating on August 1st.

Other factors are more fundamental and linked to evolving expectations of Federal Reserve policy. Recent data, including stronger-than-expected retail sales, housing starts, and industrial production, support the notion of a soft landing for the U.S. economy. The Atlanta Fed’s GDPNow tool even projects a robust 5.8% gross-domestic-product growth for the third quarter. However, this strength comes with a downside. Stronger economic growth can potentially fuel inflation, which may prompt the Fed to raise interest rates faster or maintain them at restrictive levels for an extended period – both of which would further push up bond yields.

Notably, it’s not just nominal bond yields that have increased recently; real yields, adjusted for inflation, have also climbed steadily as rates rise and inflation slows down. Until May of last year, the yield on 10-year U.S. Treasury inflation-protected securities was actually negative. However, it reached 2% on Friday, its highest level since 2009. For many investors, this after-inflation yield is attractive enough, creating increased competition for stocks, especially those with high valuations.

The Changing Landscape of Yields and Stocks

“The Creditors’ Perspective”

As financial markets continue to evolve, creditors are now making a case for their fair share. According to James Grant, editor of Grant’s Interest Rate Observer, “Creditors deserve to make a living, too.” However, not everyone is benefiting from this shift in the investment landscape. Individuals who had positioned themselves based on the expectation that negative real yields would persist find themselves in a less favorable situation.

A Tempting Opportunity

For savers, the current yields are particularly attractive. If indicators point to peaking inflation and slowing economic growth, the probability of the Federal Reserve tightening policy for an extended period diminishes. Consequently, both real and nominal yields would decrease. Furthermore, if conditions worsen substantially, such as triggering a recession scare or leading to Federal Reserve cuts, bonds purchased at today’s levels have the potential for decent capital gains. This would drive investors towards the safety of fixed income securities.

A Perilous Dilemma for Stocks

Stock markets face a challenging situation. While rising yields negatively impact valuations, a slowdown in the United States or other concerning factors, such as China’s economy, could also lead to a decline in the S&P 500. To compound matters, the upcoming earnings report of Nvidia, the company that sparked the artificial intelligence boom, will likely heavily influence market sentiment.

The Powell Factor

However, all of these factors pale in comparison to the forthcoming speech by Federal Reserve Chairman Jerome Powell at Jackson Hole on Friday. The words he speaks could very well determine whether yields continue to rise and stocks continue to fall. Dennis DeBusschere, chief market strategist at 22V Research, suggests that “Equity markets will remain under pressure while the 10-year yield is increasing.”

The Resilience of Bond Yields

Meanwhile, bond yields are expected to maintain their appeal and continue to attract interest from investors.

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