For the better part of the 20th century, except for the Great Depression, WW II, and the Vietnam War, US stocks and US bond yields tended to move in opposite directions. However, at the start of the 21st century (2000-2021), investors witnessed stocks and bond yields predominately moving in the same direction.
After a brief period of direct correlations, the two assets may return to their generational trend of trending in the opposite direction. It would imply bad news for the economy may be favorable for stocks, and good news is bad for stocks.
Today, investors welcome the idea of an economic slowdown or slower growth. In a rising inflationary environment, the Federal Reserve is inclined not to raise rates but rather cut rates if the economy is slowing too much. Bond yields will fall while stock prices rise.
Over the past two years, the pattern seems to returns to its old generational move of opposite trending, as inflationary pressures have emerged. Since Oct 2022, 10-year Treasury yields peaked at 4.333%, trading flat-to-down, while SPX bottomed at 3,491.58 (10/13/22) and trended higher.
The conflict occurs when a robust economy poses two conflicting interpretations – (1) rising profits/revenues for companies, which can lead to higher share prices, and (2) rising inflationary pressure leads to higher interest rates, which is detrimental to share prices.
In today’s environment, most investors are concerned about inflation pressure more than corporate profits. Higher bond yields result in lower stock prices, specifically in growth and technology securities. When inflation is declining or subdued, investors tend to focus more on higher profits and less on interest rates. Favorable news tends to be good for stocks regardless of higher interest rates.
A shift to the generational relationship of an opposite relationship between stocks and interest rates (yields) is challenging for investors since US Treasuries provide less protection in an investment portfolio when bonds move in the same direction as stocks (bond yields move inversely to prices). In a balanced investment portfolio, this would imply when stocks fall, bond prices will fall as well. The painful lesson occurred last year when investors could not hide in either stocks or bonds.
The Fed has raised rates at 11 of the past 12 FOMC meetings, with the most recent hike occurring in July. Target rates are now trading at 5.25%-5.5%, or a 22-year high. A critical shift in the Federal Reserve’s rate stance will soon occur as the central bank will likely pause rate increase in September.
The question is whether a rate hike in the November FOMC meeting may lead to market volatility. Although some Fed officials prefer to err on raising rates too much rather than too little, hiking rates too aggressively can trigger an economic/stock market downturn, leading to a financial/credit crisis and a hard landing.
Most economic indicators suggest that while a tight monetary policy may be appropriate today, the effect of the previous and future rate hikes can adversely impact the economy.
Some believe spending and growth data can overstate the economic strength before the onset of an economic slowdown. Historically, the Fed is prone to make a policy mistake because most economic data are backward-looking. The Fed and economists tend to be overly fixated with the lagging numbers.
The difference between one or more rate increases versus none may be the difference between a soft and hard landing.
The pertinent question for most long-term investors is whether we are moving toward the old generational trend of an opposite relationship between stocks and bond yields.
If inflationary pressure remains elevated, investors will likely stay focused on inflation rather than corporate earnings, hoping for weaker or slower growth so that this will bring interest rates lower and stock prices higher.