February 17, 2018

Treasury bond yield spike spooks stock market bulls

10 February 2018, 06:41 | Frank Carlson

By Chuck Mikolajczak

By Chuck Mikolajczak

Shares have headed south again on Wall Street. A selloff in US stocks earlier this week was in large part sparked by the February 2 monthly USA employment report which showed the largest year-on-year increase in average hourly earnings since June 2009.

While those concerns have been the catalyst for recent selling, the retreat in equities had been long awaited by investors as the market climbed nearly steadily to record highs earlier this year.

What's odd, however, is while rising rates are viewed as the enemy of stocks, history suggests that higher long-term bond yields don't have to be a threat to stocks, Don Luskin, chief investment officer at TrendMacro, noted in a report.

"Nothing seems to be going right for the world's biggest bond market: "Auctions of 10- and 30-year debt this week saw tepid demand; Japan dumped USA debt in December, making 2017 the largest exodus from Treasuries in a decade; and, as the Bank of England just * a itemscope="itemscope" itemprop="StoryLink" href="/news/terminal/P3TYO33T6SQR" class="terminal-news-story" target="_blank" rel="nofollow noopener" *reminded traders, the global economy is humming.

The sharp increase in bond yields in India over the past few weeks has been attributed to investors' concerns about the fiscal slippage in FY18 and a higher-than-expected fiscal deficit target for FY19.

Many are bracing for more wild swings ahead as the Cboe Volatility index is holding at twice its level from a week ago. To drum up demand for that higher supply, rates may have to go up.

Alexandra Coupe, associate director investment manager PAAMCO, said rising inflation made stocks less attractive. Investors should bear in mind that almost a quarter of government bonds are still negative yielding and more than 90% of bond globally still yield less than a 10 year Treasury, so the demand for yield should naturally act as a constrain on surging yield levels.

"Higher rates are going to slow the economy, we just don't know when and we don't know which rates to watch, and I think that's the debate that's now playing out in the market", he said.

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Analysts are attributing this fall to rising global bond yields, which have unsettled investors and central banks the world over.

But why are rising bond yields hurting equities?

"You don't want to move too much too soon", Ms Coupe said. That's why everybody is going back and forth. Rising bond yields, he notes, are a sign of economic strength.

Yields on bonds don't move in lockstep with Fed policy. The German 10-year yield, Europe's benchmark, climbed to its highest level since late 2015. "As it approaches 3 per cent, concerns about inflation and competition for stocks by fixed income securities are increasing". Now if you reverse PE (i.e. 1/24.53 or 4.07 per cent), you get what is called the earnings yield. Bond yields are rising as the Federal Reserve trims its United States bond holdings. The company also issued a disappointing forecast. Social-media company Twitter posted its first profit, and Yum Brands, Cardinal Health and Tyson Foods also exceeded earnings expectations. To fight inflation, central banks go hawkish on interest rates.

One worrisome thing for bond investors that's contributing to volatility is the unknown: new Federal Reserve Chairman Jerome Powell. But they're going up now at a time when anxiety about the monetary policy is obviously on the rise. And the Fed may hesitate to come to the rescue.

Stocks closed lower Wednesday, but not before swinging wildly to sharply higher and lower levels, as interest rates rose.

Simply put, when a country's macro-economic situation deteriorates, bond prices fall and bond yields rise, as investors seek more return on bonds to compensate for the risk involved.

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