When U.S. Treasury yields start to make noise, every market listens. The debt of the American government is the most important financial instrument in the world; it is the base off which almost every other yield bearing instrument is measured and is used as the “risk-free” asset in calculating discounted present value.
So, when yields start rising rapidly, meaning that the price of the bills, notes and bonds issued by the government are falling, it affects all markets. That is what we saw last week, leading to the biggest weekly drop in stocks for two years, so should investors be worried?
The short answer is no, but as is usually the case, it is not that simple.
The main reason for the jump in the yield of Treasuries week is that the market is beginning to discount future rate rises. The Fed did not move rates at their meeting but did talk afterwards of doing so multiple times later this year. They also talked about a tight labor market beginning to push wages higher, leading to more robust consumer spending that in turn will probably push prices up.
In short, for the first time in years the Fed, and therefore the market, is contemplating the prospect of inflation. That comes from the reasons the Fed laid out, but also from fiscal policy like the tax cuts that is growth oriented, even as those conditions arrive.
Under normal circumstances, a small amount of inflation can be good for stocks, as their price in dollar terms rises along with everything else. What is different this time around is that the conventional wisdom is that much of the gains in the stock market are the result of equities being attractive relative to bonds because of low rates.
Warren Buffett, for example, made exactly that point in an interview with CNBC back in October. It is only logical, therefore, that if rates start to jump, there will be selling of stocks.
What that ignores, however, is the other thing driving stocks higher; the most fundamental factor of all in calculating the value of a business: profits. We are seeing strong earnings from a lot of companies from Q4 of 2017, and that trend looks set to continue as corporations benefit from a much lower corporate tax rate and easier, cheaper, repatriation of profits held overseas.
In addition, while a ten-year note that yields close to 3% looks shocking after nearly a decade of ultra-low rates, it is not that big a deal. One of the good effects of that, as stated many times by Janet Yellen and her predecessor Ben Bernanke, is that when the time comes to put the brakes on, it should be able to be done without pushing interest rates to a level that would seriously discourage investment.
From a technical perspective, looking at the above chart for the S&P 500, if we break this 2740 level the next logical support comes around 2650, which would mean giving up all this year’s gains. Early evidence this morning, however, suggests that 2740 is holding, and following a day like Friday, a bounce of some kind is to be expected.
That may be of interest to traders, but for most investors, who have a much longer-term outlook, it is irrelevant. What they should be asking themselves is, is this a correction, or the beginning of a collapse?
Right now, the only logical conclusion is that it is the former. The problem here is one of growth that some are fearing is going to be too robust, and while that can cause some short-term jitters for stock traders it is a good problem to have for most companies.
The Fed is aware of the potential for overheating and has lots of room to combat it if it comes. If they choose to do so it will undoubtedly cause volatility in the future, and we should get used to that idea, but the fundamental factors suggest that we can continue higher, even if not in a straight line. That will create some good trading opportunities, but for most investors it will be a time to remember that ultimately corporate profitability drives stock prices, and earnings are still growing.