The recent surge in the benchmark 10-year U.S. Treasury bond yield to nearly 5% has prompted a significant shift in the investment landscape, compelling investors to reassess their asset allocation strategies. This movement marks a notable departure from the low-interest-rate environment that has prevailed since 2007, challenging the conventional wisdom that has guided investment decisions for over a decade.
Recently, the 10-year yield reached a peak of 4.997% before experiencing a slight retreat to 4.9% on the following day. This fluctuation represents a substantial increase of 79 basis points since the beginning of September, continuing upward from 3.3% in just over six months.
The ripple effects of this yield increase were immediately felt in the stock market, with the Standard & Poor’s (S&P) 500 Index experiencing a decline for four consecutive days, culminating in a weekly loss of 2.4%.
The downturn in equities is a typical response to rising bond yields, as bonds begin to present a more attractive yield proposition to investors, thereby diverting capital away from stocks.
Can the equity market sustain its upward trajectory during this traditionally favorable seasonal period if the 10-year Treasury yield remains at its current level and potentially rises above 5%? For an extended period spanning over a decade, investors have predominantly leaned on stocks for growth and bonds for stability, a strategy facilitated by an environment of historically low interest rates.
The S&P 500 Index, for instance, rebounded robustly from a 37% plunge in 2008, registering annual losses in only two of the subsequent 14 years and achieving double-digit gains in all but four of those years. Concurrently, bond values remained relatively stable due to the steady nature of interest rates during this period.
However, this investment paradigm shifted as the Federal Reserve embarked on a series of interest rate hikes last year. Stock investment circles generally dislike this development. Higher interest rates translate to increased bond yields, which, in turn, heightens the competition between bonds and stocks for investor capital. Additionally, rising bond yields indicate selling activity in the bond market, particularly in the Treasury market, reflecting a supply-demand imbalance for U.S. government securities.
In the latest government data, the yield on the 10-year Treasury note has surpassed consumer inflation by over one percentage point. This marks a significant milestone, as it represents the first time in years that investors are experiencing a positive “real” rate of return on the 10-year note.
Furthermore, the allure of cash-oriented investments has been enhanced by rising interest rates, reaching 6.5% on money market accounts and certificates of deposit, presenting a virtually risk-free investment option, barring inflation.
The S&P 500’s recent dip below its 200-day moving average has raised questions about the sustainability of the bull market that commenced in early June. Since then, the index has declined by 1%, a trend exacerbated by the pressure from rising yields.
Quincy Krosby, Chief Global Strategist at LPL Financial, believes that the ongoing third-quarter earnings reporting season could play a pivotal role in determining the short-term trajectory of stocks, irrespective of the prevailing interest rate conditions. She posits that robust earnings and positive guidance could potentially offset the adverse market impacts of rising rates, and a shift in investor sentiment away from the expectation of a guaranteed year-end rally could pave the way for a contrarian-driven market rally.
On the bond market front, conventional wisdom suggests that rising Treasury yields should attract more investors to U.S. government securities. However, the current yield increase seems to reflect increased bond issuance by the federal government, driven by the need to finance its fiscal budget deficit, coupled with a diminishing pool of willing buyers. This year has seen $15.7 trillion in new securities issuance, marking a 26% increase from the previous year. Concurrently, the Federal Reserve’s rate hikes have escalated the government’s debt-service costs to their highest level since 2009.
The traditional heavyweights in Treasury purchases, Japan and China, have been diversifying their investment portfolios, reducing their holdings of U.S. government securities to $2 trillion, constituting a mere 8% of all U.S. debt. This is a significant reduction from their peak ownership of 25% in 2007. With the U.S. government having little choice but to continue issuing new debt to cover its expanding costs, Treasury yields are likely to remain elevated. This, in turn, could exert upward pressure on corporate bond yields as companies strive to remain competitive in attracting capital, potentially leading to a depreciation in the value of existing bonds.
Related articles:
Beyond Stocks: Broadening Your Retirement Portfolio For Better Security
How ETFs Are Revolutionizing Retirement: And Why You Should Care
Why Everyone Will Regret Not Jumping on the Roth IRA Train