By Lewis Krauskopf and David Randall
NEW YORK (Reuters) – Whipsawed US stocks have gained an unexpected ally in recent days – a historic plunge in bond yields.
US Treasury yields fell precipitously this week, with some maturities marking their biggest fall in decades, as investors bet the Federal Reserve was likely to rein in its aggressive stance on rate hikes in an attempt to aggravate financial system stress following the Silicon Bank collapse Avoid Valley Bank and Signature Bank.
Volatility in bond markets has unsettled investors, and falling yields may reflect expectations that the Fed will cut rates on a slowdown in growth.
At the same time, the fall in yields so far has been a boon for stocks, particularly technology and other large growth stocks, whose relatively strong performance has helped support the benchmark S&P 500. The index ended the week up 1.4%, with strength in technology stocks outweighing sharp falls in bank stocks.
While the banking crisis has stoked recession fears, “it’s the rate action that’s giving stocks … a tailwind right now,” said Charlie McElligott, Nomura’s managing director of cross-asset macro strategy.
The near-term direction in yields will likely depend on next week’s Federal Reserve meeting. Signs that the central bank may prioritize financial stability and slow or suspend rate hikes could drag yields further lower. Conversely, yields could rebound if the Fed signals that cutting inflation – which remains high despite a spate of rate hikes – will remain a task.
“The market isn’t quite sure how the Fed will react to this,” said Garrett Melson, portfolio strategist at Natixis Investment Managers Solutions.
For now, futures markets are suggesting that investors see a 60% probability of a 25 basis point rate hike at the Fed’s March 21-22 meeting, followed by rate cuts later in the year – a sharp reversal from the previously prevailing hawkish expectations this month.
The story goes on
“For the first time in this Fed tightening cycle, the Fed must now balance its credibility in fighting inflation with the stability of financial markets,” said Michael Arone, chief investment strategist at State Street Global Advisors.
Treasury yields fell to all-time lows after the Fed cut rates to support the economy at the start of the COVID-19 pandemic, fueling a stock market rally that saw the S&P 500 recover from its March 2020 low point doubled.
A year ago, when the Fed began tightening monetary policy to combat inflation, government bond yields began to rise, providing investors with an increasingly attractive alternative to equities. Two-year yields, which were recently at 3.85%, hit an over 15-year high of 5.08% earlier this month.
According to some indicators, the recent drop in interest rates has helped equities to become more attractive again. The equity risk premium, or the additional yield investors expect for holding equities versus risk-free government bonds, has returned to where it was in early January but still remains near its lowest level in over a decade, according to Refinitiv data.
Other metrics show stocks remain expensive by historical standards. The S&P 500 is trading at 17.5 times forward earnings estimates, compared to its historical average P/E of 15.6 times, according to Refinitiv Datastream.
The rally in rate-sensitive areas like technology stocks seems to signal that the market expects rates to fall further as a widely feared recession looms, Nomura’s McElligott said.
The information technology sector and communications services sector of the S&P 500 were up over 5% and nearly 7%, respectively, on the week, helped by strong gains in megacap stock Microsoft Corp and Google parent Alphabet Inc.
However, some investors are skeptical about stock valuations. Bob Kalman, senior portfolio manager at Miramar Capital, said the Nasdaq 100 should trade no more than 25 times expected earnings, below its current 27.3, given current interest rates.
“People have this muscle memory to buy mega-cap tech when they get nervous,” Kalman said. “But the Fed hasn’t backed down its rhetoric that it knows it needs to overshoot because inflation is a much bigger problem in the economy than a few bank failures.”
(Reporting by Lewis Krauskopf and David Randall; Editing by Ira Iosebashvili and Richard Chang)
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