Why inventory traders are beginning to actually fear about rising bond yields

Federal Reserve Chairman Jerome Powell testifies before the Senate Banking Committee hearing on the Quarterly CARES Act Report to Congress on Capitol Hill, Washington, December 1, 2020.

Susan Walsh | Pool | Reuters

Stock investors are desperate to interpret what an increase in bond yields will mean for the stock market.

Since February 10, 10-year government bond yields – which are not adjusted for inflation – have risen from 1.13% to 1.61%. This corresponds to an increase of 48 basis points, the highest level since the beginning of the year. (One basis point equals 0.01%)

Fear of inflation is leading investors to speculate that the Federal Reserve may have to change its policy sooner than expected, either by reducing bond purchases or even increasing interest rates at some point. That would be negative for stocks. The Dow lost 559 points on Thursday.

Academy Securities’ Peter Tchir says the recent rise in 10-year bond yields is a perception of inflation, but not necessarily a reality: “The rise in 10-year bond yields does not reflect the actual rise in inflation, it mirrors it Investor Expectations Against Inflation will rise, “he told me.

Tchir notes that Federal Reserve Chairman Jerome Powell opposed the idea of ​​excessive inflation and notes in his testimony that there have not been broad signs of inflation in the real world and that if they did occur, are there at all such increases would be “transient”.

Who’s Right About Inflation?

Bond investors are concerned about the potential for inflation. Powell says to stop worrying about it. Who is right?

It depends on who you ask and what you see.

Are we seeing inflation in the real world? We’re doing this with commodities: oil, for example, is nearing its highest level since 2018, and copper is at nearly a 10-year high.

For example, signs of consumer inflation are subdued, with inflation hovering at or below 2% for many years.

Bulls like Tchir insist that in this case, the rise in bond yields is not negative on stocks: “This time, the rise in returns is due to economic growth, momentum and infrastructure. All of this is good for stocks. Therefore, this rise doesn’t bother me too much Fear. “

He says the surge in commodity prices can be easily absorbed and believes that much of that surge is just a temporary condition reflecting the reopening and that prices will return to “normal” levels over time.

Hans Mikkelsen, credit strategist at Bank of America, isn’t so sure. He agrees with Tchir on economic growth, but believes it will be much stronger than expected and this will drive inflation higher: “Since the summer of 2020, economists have seen economic growth at unprecedented levels consistently underestimated. There is a real risk that the Fed will not be able to sound cautious for long and that transition could lead to wider credit spreads. “

Shares on the verge

Tchir insists that the key to the game is whether Powell can hold on to his guns: “If the Fed continues to be determined to keep short-term rates low, it will bring comfort to the people and we will not have a fit of anger where interest rates suddenly rise. ” Powell has told us that he is happy with inflation and will not respond to short-term moves. I think he will hold onto his guns. “

There’s another problem too: because stock prices are so high, there’s no room for error. Small shifts in returns could lead tech investors in particular to take profits, assuming this is the best they can.

Senior equity commentator Michael Farr of Farr, Miller & Washington has told clients that even this relatively modest rate hike is a signal: “The days of market leaders piling up regardless of valuation may be coming to an end. Investors must now acknowledge that there are alternative options out there, including both previously subpar stocks and incrementally more attractive bonds. A strong economic recovery, combined with rising interest rates and higher inflation, if that materializes, will make sense of the investment background change. “”

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