This week, the ten-year US Treasury Bond Yield breached the psychologically important 3% level. Several prominent fixed income investors, including Jeffrey Gundlach, have claimed that crossing the 3% threshold is a critical factor in determining if the three-decade bull market in bonds has run out of steam. There is a school of thought, based on historical market patterns, that once the yield breaks much above 3.05, the threshold could quickly switch from a ceiling to a floor. Breaking out above 3% is also considered a signal that markets are sure the Federal Reserve (Fed) will be forced to increase rates more quickly. The concern now is that the Fed raises four times, rather than the prior consensus of three, and the yield is pushed higher still.
This upward rate trajectory will undoubtedly have a negative impact on equity markets. Stocks are first and foremost affected by higher bond yields due to becoming less attractive versus secure bonds. This is particularly the case for high dividend stocks which have acted as “bond proxies”. Equity values are impacted by the application of a higher discount rate to future earnings. Finally, the expectation of reduced access to cheap capital for funding growth and stock repurchases, is also a negative factor. The reaction of the S&P 500 Index to the 3% level breach was, however, relatively muted; by Thursday the Index had recovered most of its 1.2% loss over the previous two sessions. In fairness, the Fed has been pointing to rising inflation since the start of the year, giving investors time to prepare for higher yields. However, if the Fed ramps up its tightening agenda, that could slow down the economy which will impact stock valuations.
Another concern that continues to rattle investors is the narrowing spread between the yield of long-term and short-term bonds. The spread has narrowed to approximately 0.5%, compared to 0.6% at the start of 2017. When the yield on the two-year Treasury exceeds that of the ten-year, it often signals a recession. However, several commentators argue a recession looks highly unlikely, given the unemployment rate is approaching sub-4% and suggest it would take some very aggressive rate increases to derail the robust economic growth currently being enjoyed in the US.
Meanwhile in Europe, the European Central Bank (ECB) signalled no change to its monetary policy, sticking to its promise to continue the asset purchase programme past September “if necessary”. The Bank also restated that it would keep interest rates at current record lows beyond the closing of the programme. The ECB is out of step with its counterparts in the US and the UK, with both the Fed and the Bank of England expected to raise rates this year. Following the ECB’s comments, the Euro fell to its lowest level against the Dollar since January.