The Bond Market and Rising Rates

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The bond market has continued to sell off in October and in turn, long-term yields have risen to near-seven-year highs. This has spooked stock market investors, causing the S&P 500 to sell off aggressively. The S&P 500 has dropped 5.58% month-to-date (MTD), as of October 22, 2018.

The stock market’s reaction to this was delayed, which led many to discuss that a range of risk factors may have caused the sell-off in stocks. As you can see below, the bond market began selling off heavily on the third of October.

Corporate bond yields have risen this week, gaining around ten basis points on average. This is in-line with the stock market sell-off. More money is headed towards low-yield, safer investments as the perceived risk within stocks rises.

The Blame: Real Interest Rates?

The 10-year US treasury note’s real (inflation-adjusted) interest rate has just broken out of a five between 0% and 1%, now trading at 1.04%. Many are blaming this chiefly for the sell-off in stocks and it makes sense. The US credit markets have made it extremely cheap for businesses to borrow money for the last ten years, financing the growth of many companies that would have died in higher interest rate environments.

With interest rates at historic lows (see chart below), this rise in real rates probably isn’t the last rise. With cost of capital being highly important for unprofitable growth firms, real rates continuing to rise can threaten the existence of many of these firms. Peter Boockvar, CIO of insurance firm Bleakley Financial Group, told Bloomberg that “In a credit/debt dependent U.S. economy, and global economy for that matter, there is no greater input than the cost of money” last week.

Bond Market Effect on S&P 500

As you can see in the chart below, the S&P 500 shortly breached a key psychological level for traders and investors: the 200-day simple moving average. It has since recovered and closed just one point above the moving average.

It’s the confluence of a few factors that likely caused such a dramatic move downward: Fed Chairman Jerome Powell’s hawkish rhetoric at September’s FOMC meeting, President Trump’s disapproval of the Fed’s conduct, long-term bond yields rising, and more privacy concerns in tech, the S&P 500’s most heavily weighted sector.

Treasury Yield Curve

In summer 2018, the US Treasury yield curve began to flatten, meaning that the 10-year Treasury note’s yield is similar to that of the 2-year Treasury note (see graph below). The flattening or inverting of the yield curve is considered a leading indicator by most economists and market analysts, and has predicted many recessions.

Essentially, the spread between the 10-year and 2-year Treasury notes being low or negative has historically shown to be a good signal of recession.

However, with the above in mind, it’s also key to note that the real (inflation-adjusted) 2-year rate is still only about 54 basis points, when factoring in the current inflation rate of 2.3%, and the current nominal 2-year yield of 2.85%.

Summary

Long-term bond yields have risen
The 2-year Treasury Note’s real-yield has broken out of it’s 5-year range
The real yield curve is flattening
Stock market investors are reacting to this data with fear, with the S&P 500 experiencing its worst trading day since February 2018.

Article By: Patrick Crawley

The Bond Market and Rising Rates

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