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Good morning. The initial plan today had been to reflect on Fitch’s downgrade of US debt, but we could find no reason to dissent from the consensus view of the rating agency’s view: that the report is both irrelevant to the bond market and very oddly timed. So we skipped it. We’re more interested in what Apple and Amazon results — both of which come today — have to say about the US economy. Email us: [email protected] and [email protected].
Long bonds and equities
Long Treasury yields are approaching the highs that they hit back in the autumn of last year, in both nominal and inflation-adjusted terms:
This fact has not attracted much comment, perhaps because of the cheery mood in markets generally and because there is plenty of other news. Still, I think it’s a big deal and demands some reflection, not least among equity investors, who have (at least until yesterday) been enjoying a stonking 2023 rally. Bond yields and stock valuations do not (as is often assumed) have a regular relationship through time, but there is some reason to think that, at the current moment, rising yields and the hot stock market are in tension.
It is odd, from one simple point of view, that long yields should rise just as worries about inflation are falling away. While inflation and Federal Reserve policy are most tightly linked with short rates, long rates are just the sum of expected short rates through time, plus a term premium. The term premium is currently negative. So recent evidence of disinflation should, all else being equal, tamp down long yields, because short yields are likely to have peaked.
This was the basic thinking behind our newsletter of a few weeks ago arguing that owning log-dated bonds was becoming more appealing:
The 10-year Treasury yield has not moved much since the autumn of last year, but the inflation situation is both clearer and more benign. Rates volatility appears to be easing off. If we are on the way back to normal after a bout of supply-shock inflation, then locking in a 3.8 per cent yield for 10 years — when pre-pandemic long yields were quite consistently below 3 — seems like a logical bet.
Well, 10-year yields are nearly 4.1 per cent now, and the inflation outlook is the same, so that story should be even more compelling now.
But inflation is only half the story, of course. The news about growth has been good, too. This means implied probabilities of recession are down, which should reduce the appeal of risk-free Treasuries, and push yields up. Our excellent colleague Kate Duguid points out that the biggest recent daily move up in long yields came on July 27, the day of the ebullient report on US GDP in the second quarter.
The growth-based story fits with the recent negative correlation between bond prices and equity prices. Stocks have risen alongside yields in recent weeks, as they often do when growth is solid and inflation fears are under control. But high yields are not only a reflection of good growth prospects. I asked Bob Michele, chief investment officer at JPMorgan Asset Management, what he made of the recent move up in long bonds. His reply:
The market is pricing in a Fed that will remain restrictive for a long period of time.
We prefer to look at yields in real terms. While 10-year real rates have risen to cycle highs, it is because front-end real yields (most often associated with policy stance) have continued to move higher. In fact, 5-year real yield 5-year forward [that is, the implied 5-year real interest rate five years from now] are within the range they traded since December, while 2-year and 5-year real rates are at or above the cycle highs (3% and 2%, respectively).
It remains to be seen how well the economy can handle such restrictive policy rates. We see 10-year yields at these levels reflecting attractive valuations in both real and nominal terms.
In other words: higher longer yields now reflect tight monetary policy, but that restrictive policy may well depress growth — meaning lower rates later. So buying duration makes sense.
Unhedged would push Michele’s interpretation a step further and suggest caution about stocks, which might not enjoy such a firm economy for much longer (as we argued yesterday). Making matters worse for stocks, high real yields give investors an attractive alternative. Days like Wednesday, when yields rise and stocks fall, fit with this logic.
Our view comes with an asterisk, however. Several of our contacts and colleagues have pointed out technical or structural reasons for rising long yields, none of which are directly related to US monetary policy, inflation and growth. These include the effect on Treasury demand of the Bank of Japan’s loosening of yield curve control; traders’ closing of profitable “curve flattener trades” (buy the long end of the curve, sell short the short end); mortgage convexity hedging; and the Treasury’s recent announcement of greater impending issuance of new long-term debt. Depending on how much influence you think these factors have on long yields, and how long you expect that influence to last, your appetite for duration will vary.
Still, we are inclined to keep it simple. One does not have to equate higher bond yields with lower equity valuations to think that, in the current moment, rising long yields will put pressure on stocks. Those yields reflect restrictive monetary policy that will probably depress economic growth and present an attractive alternative to stock ownership.
One good read
Patrick Radden Keefe has written an insightful profile of the art dealer Larry Gagosian for The New Yorker — a much more detailed portrait than my much shorter effort on the same subject for How To Spend It.