Do you remember when the yield on the 10-Year Treasury Note was a big deal? I suspect that you will, as it was only four months ago. Back in May, when the benchmark 10-Year was approaching a three percent yield it was seen as highly significant, with predictions of doom commonplace.
Most notable among them was the assertion by veteran Wall street trade Art Cashin on CNBC that “…all hell would break loose…” in the stock market if that psychologically important level was broken. Contrast that to today, where yields have returned to their May highs with very little hoopla, and the obvious questions are: What has changed, and should investors care?
The simplest, if somewhat flippant answer to the first question is that all that has really changed is the focus of the media. Fear sells, and right now, with ever escalating trade tensions with China, there are a lot of other scary things to report. Less cynically, it is probably that having breached what looked like such an important level once and then retreated, 3% looks a lot less significant the second time around.
From that perspective the move up in yields seems less worrisome now than four months ago, but still the answer to the second question is that yes, investors should care. That doesn’t mean however, that they should panic.
The concern comes from the fact that while Cashin’s prediction looks hyperbolic with the benefit of hindsight, it seemed quite reasonable at the time and was based on simple logic that is as true now as it was then. If you listen to politicians, it is the enlightened policies of the Trump administration, or, if you prefer, the Obama administration, that have caused the stock market to rally so strongly since the recession and hit record highs.
If you listen to economists, traders, investors, and commentators without a political agenda though, the strength in the stock market has a couple of more fundamental causes: cheap money and low bond returns.
Investing decisions essentially come down to a choice. Do you opt for a lower return in relatively safe areas, or do you seek a better reward by taking on more risk? That is a complex decision, but when the return you receive on a safe bond investment is effectively zero it becomes a lot simpler. For the last nine years that has been true, so favoring stocks over bonds has been a no-brainer.
That has forced stock indices higher, but the move up has been exaggerated by the other effect of low interest rates. The Fed pursued their post-recession policy of ultra-low and zero interest rates for a reason. They wanted to encourage investment, and cheap money does that. If a company has to pay only a couple of percent interest on a ten-year loan an awful lot of investments look viable.
Similarly, if a consumer can borrow cheaply, major purchases, house improvements or whatever seem like a good idea. All that activity boosts corporate profits, and therefore stocks.
So, as yields move higher, it is a double whammy. Not only does it put a damper on economic activity, it also makes stocks relatively less attractive to investors. That’s the bad news, but as I said above it is not a cause for panic. There is some good news too.
There are a couple of things that are different about this week’s move. In May the move up in the 10-Year wasn’t reflected at the long end of the yield curve, meaning that the effect of the change in the 10-Year was to flatten that curve.
Without getting into too much technical detail, curve flattening is generally seen by traders as a bad sign. This time the move up in rates has been all along the curve, suggesting an expectation of sustained growth.
That can be a positive in a broader sense too. As I said last month, the persistently low rates at the long end of the curve could easily have an explanation that, far from being a worry, is actually reassuring. It could reflect a belief that the Fed can avoid the wild swings in the economy that we have seen in the past and indicate an expectation of long-lasting, steady growth.
Just because the most recent move above a 3% yield on the 10-Year hasn’t attracted much attention then, it doesn’t mean that it is meaningless. The reasons for the original concerns still exist, but the manner of the move and the expectations and perceptions surrounding it make it less of a worry now than just four months ago.
Investors should be watching the yield curve for further rises or more flattening, but for now assume the best and carry on.