This week, central bankers will meet virtually at Jackson Hole, Wyoming. All eyes will focus on comments from the Fed’s chair, Jerome Powell, and specifically on his plans to taper and other monetary policies to reduce the economic impact of the Covid-19 pandemic.
The question is not if the Fed will taper but when will they taper. So, the next question then becomes - will quantitative tightening lead to Treasury yields rising sharply higher? And, if so, will this trigger an economic slowdown and a stock market peak?
When Fed reduces its $120 billion per month bond-buying program, they will be buying fewer Treasuries. Based on supply and demand, fewer bond purchases translate to higher yields. However, a tighter monetary policy also implies less economic growth and a lower inflation rate, longer-term. Investors will anticipate this policy change, forcing bond yields to decline.
The real question is the balance between the less Fed buying of bonds and the perception on the policy tightening will determine whether 10-year yields rise or fall. The recent fluctuations in the 10-year Treasury yields (TNX) suggest investors are unsure as to which of the above scenario will occur.
TNX remains in a tight trading range between 0.90-1.0% and 1.70-1.765%, near-to-medium term. Above 1.765% warns of higher yields, suggesting the next rally toward 1.903-1.971% (Sep/Nov/Dec 2019 highs). Below 0.90% hints of lower yields, with yields declining toward 0.5404-0.543%, and below this to 0.398% (3/9/21 low).
Last week, stocks and commodity prices declined soon after the release of the Fed minutes, as the central bank tilted toward a tapering of the bond-buying program later in the year. After rising briefly, 10-year yields reversed direction and declined. The yield’s erratic movements and the increased volatilities in the stock and commodity markets suggest investors are unsure at the Fed taper is good or bad for the financial markets.
Reducing the Fed bond-buying may be bad for stocks. However, the word “bad” is subjective and open to various interpretations. Tighter monetary policies are bad for stocks in general. However, the firmer economic growth associated with higher yields can also force the Fed to tighten its policies to cool an overheated market. Under this scenario, it may be less bad for stocks. Since 2000, this relationship between stocks and bonds has shown a near-term correlation between rising yields (falling bond prices) and higher stock prices. Over many years (i.e., decades), stocks tend to rally when yields trended lower.
From a technical perspective, stocks and bonds are typically inversely correlated. However, from May 2006 to Feb 2009 and from Jul 2016 to Oct 2018, stocks (S&P 500 Index - SPX) and bonds (30-year US Treasury Bond - USB) the two asset classes decoupled from each other. Most recently, starting in Mar 2020, USB and SPX have again diverged. Are the FED interventions (QE and bond-buying programs) in the US fixed income market during financial/geopolitical/medical uncertainties exerting undue influence on the direction of the USB and SPX? What will happen when the FED withdraws from the bond markets?
Stocks begin to underperform under a restrictive monetary policy because of inflation, even when growth begins to stall. We have rarely witnessed this type of combination since the 1990s. However, the weaker-than-expected economic data released in recent weeks, coupled with one of the highest inflation rates since the early 1980s, are starting to concern many investors.
Another development that needs to be monitor is the performances of economically sensitive stocks (reopening names), technology-driven growth stocks (stay-at-home or work-from-home), and defensive stocks (consumer staples, utilities, pharmaceuticals, and real estate). Last week, many cyclical sectors sold off when the Fed announced its intentions to taper. Defensive areas such as consumer staples, utilities, pharmaceuticals, and real estate stocks rallied, also rallied, benefiting from lower bond yields and the flight to safety rotation. The mega-cap Techs also held up well last week as they tend to perform well when bond yields decline, and investors seek growth. The biggest technology names in the SPX Index now account for over a quarter of the overall SPX market cap. These large-cap tech names will likely continue to unduly influence SPX regardless of whether the economically sensitive S&P 500 names rallies or correct.
The daily Relative Rotation Graph (RRG) study for the past ten (10) trading days ending on August 23, 2021, shows four S&P sectors trending higher – Technology (XLK), Healthcare (XLV), Utilities (XLU), and Consumer Discretionary (XLY). During this 10-day window, SPX gained 7.8%. The outperformers were XLK (+11.2%), XLV (+10.5%), and Utilities (+8.5%). The underperformers were many of the economically sensitive sectors, including XLY (+4.7%), Industrials (XLI +4.2%), Materials (XLB +5.1%), and Energy (XLE -8.2%).
So, are higher bond yields good or bad for stocks? It appears investors are unsure. It may depend on the type of economic environment we are in. And most importantly, whether the Fed is focusing too much on fighting inflation (perceived or real) and not enough attention on helping the economy recover from the pandemic. Under this scenario, rising bond yields may be bad for stocks, as it is not a reflection of stronger economic growth, which is good for stocks, but the perception of the Fed may be prematurely curtailing the economic recovery and hence the stock market rally.
The more the street and the Fed focus on inflation and the possibility that this can lead to stagflation, the more likely stocks and bond yields will decouple from their normal historical tendencies.
Although the comments from Chairman Powell this coming Friday can lead to bond yields rising or falling, it may be more important to determine if this policy shift can alter the historical relationship between Treasuries and stocks.