Federal Reserve Chairman Jerome Powell testifies before the Senate Banking Committee hearing on “The Quarterly CARES Act Report to Congress” on Capitol Hill in Washington, Dec. 1, 2020.
Susan Walsh | Swimming pool | Reuters
Equity investors are desperate to interpret what an increase in bond yields means for the stock market.
Since February 10, the interest rate on 10-year Treasury bonds – which has not been adjusted for inflation – has risen from 1.13% to 1.61%, up 48 basis points, the highest level in a year. (One basis point equals 0.01%)
Fears of inflation are leading investors to speculate that the Federal Reserve may need to change policy sooner than expected by reducing bond purchases or even raising interest rates at some point. That would be negative for stocks. At last count on Thursday, the Dow was 500 points behind.
Peter Tchir of Academy Securities says the recent rise in 10-year bond yields represents a perception of inflation, but not necessarily the reality: “The rise in 10-year bond yields does not reflect an actual rise in inflation, it reflects investors expect there will be an increase in inflation, ”he told me.
Tchir notes that Jerome Powell, chairman of the Federal Reserve, opposes the idea that excessive inflation is coming, noting in his testimony that in the real world there have not been broad signs of inflation, and if they do occur, such increases would be “transient”.
Who is right about inflation?
Bond investors are concerned about possible inflation. Powell says we shouldn’t worry about it. Who is right?
It depends on who you ask and what you are looking at.
Are we seeing inflation in the real world? We do this in raw materials: oil, for example, is approaching its highest level since 2018 and copper is at its highest point in almost 10 years.
But signs of consumer inflation have been muted, for example, with inflation of 2% or less over many years.
Bulls like Tchir insist that in this case the rise in bond yields is not negative for equities: “This time the rise in interest rates is due to economic growth, stimulus measures and infrastructure. That’s all good for equities. That’s why this rise makes me not too scared. “
He says the rise in commodity prices can be easily absorbed, and believes much of that rise is only a temporary condition reflecting the reopening, and prices will return to normal over time. levels.
Hans Mikkelsen, credit strategist at Bank of America, is not so sure. He agrees with Tchir on economic growth, but thinks it will be much stronger than expected and will drive up inflation as a result: “Since the summer of 2020, economists have consistently underestimated economic growth to an unprecedented magnitude. a real risk to the Fed. will not sound moderate for much longer and that transition could lead to wider credit spreads. ”
Stocks on the edge
The key to the game, Tchir points out, is whether Powell can stick with his feet: “ If the Fed remains committed to keeping short-term yields low, it will give people comfort, we will not get ‘taper tantrum’, where interest rates suddenly skyrocket. Powell has told us that he is comfortable with inflation and will not respond to short-term moves. I think he will stick to his guns. ‘
There is another problem: because stock prices are so high, there is no room for error. In particular, small shifts in yields can cause tech investors to take profits, assuming it’s the best it can be.
Veteran stock commentator Michael Farr of Farr, Miller & Washington has already told clients that even this relatively modest interest rate hike is a signal: “The days of simply piling up to the market leaders, regardless of valuation, may come to an end. Investors must now recognize that there are There are alternative options, including both so far underperforming stocks and incrementally more attractive bonds. A vigorous economic recovery coupled with rising interest rates and higher inflation, if indeed happening, will meaningfully change the investment backdrop. “