Last week the yield on 10-year Treasuries triggered alarms when it hit its highest level in a year. Many attributed last week’s stock market selloff to that jump in yield, with concerns of continued increases that could lead to further market weakness. We don’t share those concerns for two reasons: 1) We believe the recent rise in yield is not a trend, and 2) even if it were, we don’t think it will negatively impact the stock market. Here’s our reasoning:
No Change in Bond Market Fundamentals
While we can’t ignore the sharp increase in the 10-year Treasury yield, which bottomed out at 0.5% in August and now sits at 1.49%, this triggered alarms because the 10-year yield wasn’t expected to rise that much in 2021. The median year-end forecast was 1.21%. While the current yield is well above that level, we don’t expect it to rise significantly from here. We could even see the yield fall back from here. The reason is there isn’t likely to be any material changes in the supply and demand fundamentals of bonds in the current environment.
In terms of supply, we’re not seeing much in the way of new 10-year bond issues. While the government is borrowing at a record pace, most of its debt sales were centered around short-term Treasuries of five years or less. It’s possible that the government could shift its debt sales to longer-term Treasuries; however, based on the Treasury Borrowing Advisory Committee’s recommendation, the government will likely stay focused on short-term debt sales at least for the first two quarters of 2021.
On the demand side, the last auction of $41 billion 10-year Treasuries, though slightly smaller than January’s auction, was twice oversubscribed, indicating strong demand. It could be that a drop in subscriptions for the January 7-year Treasury auction may have triggered the yield jump, but it was still oversubscribed, which doesn’t indicate a trend. Meanwhile, for its quantitative easing program, the Fed is continuing to buy up long-term Treasuries in the secondary markets, creating a sustained source of demand amid shrinking supply, and there is no indication it plans to stop anytime soon.
Rising Yields Don’t Necessarily Translate to Market Declines
The idea that rising Treasury yields automatically translates to market declines is mostly a myth. While we can count a few periods when a market downturn occurred alongside rising bond yields, historically, rising yields have mostly occurred alongside rising stocks. That has been the case even when rates have increased by multiple percentage points as they have seven times in the last five decades. The most recent increase from Aug 2020 through Feb 2021 is nearly one percentage point. The following chart provides a broader historical perspective.
While history provides some perspective, it doesn’t ensure things won’t be different this time around. But, from our view, the direction of bond yields doesn’t inevitably impact stocks. Stock prices are predominantly driven by corporate earnings looking forward a year or two into the future. However, bond yields can have some effect on a company’s earnings outlook, primarily if it’s in a rate-sensitive sector or it relies heavily on debt to finance its operations. But, generally, rising rates are an indication of a growing economy, which typically bodes well for stocks.
The current bond market fundamentals don’t seem to point to any significant yield increases for the remainder of this year. However, there is still potential for higher yields at some point which could introduce risk in the future. For instance, if rising yields persist and steepen the yield curve even further, it could lead to higher inflation, which, by the way, we don’t think is a bad thing. The real danger is if the Fed overreacts by increasing short-term rates too far, too fast—a sure way to end a bull market. But that is not a risk we face in the foreseeable future.
The bottom line is history shows that the direction of the stock market doesn’t necessarily depend on
the direction of bond yields. Stocks and bonds are uncorrelated assets, sometimes moving together,
sometimes moving differently, but always for their own fundamental reasons.
Why We Welcome Rising Interest Rates and Inflation
We create ballast to our portfolios against the threat of rising interest rates or inflation by investing
exclusively in high-quality, well-managed companies with strong brands and dominate market positions. If
they carry little or no debt, they are mostly immune to rising interest rates. If they dominate their markets,
they enjoy the kind of pricing power that allows them to raise prices in response to inflationary pressure
to maintain earnings growth. That’s precisely the “High-Quality Company” strategy we use at Dash
Investments and why we are well positioned should interest rates or inflation rise now or in the future.