Why are stock markets and bond markets on a collision course on US interest rate cuts?

Yields on the 10-year US treasury bond is at a two-decade high even as stock valuations remain elevated
Yields on the 10-year US treasury bond is at a two-decade high even as stock valuations remain elevated

In the world of finance, the relationship between U.S. Treasury bond yields and the stock market has traditionally been inverse: when bond yields rise, stocks tend to fall, and vice versa. The logic behind this inverse relationship is grounded in fundamental economic principles.

Another, more recent reason is that when US treasury bond yields rise, it indicates that bond-market participants expect the US Federal Reserve to maintain its relatively high interest rates. This is considered a contra-indicator for stock markets as current stock valuations, like the prices of other assets such as real estate, is depend on the continuation of the ‘easy money’ policies the US central bank has been following for the last 14 years.

The easy money policy would require the US Federal Reserve to cut its interest rates back to the 1-2% range in the next 12-18 months, but the yield on the 2-year, US treasury bond has jumped from around 4% in May to around 5% at present. This is its highest level since the global financial crisis of 2008.

Similarly, the yield on the 5-year T-bond has reached its 15-year high of around 4.4%. Yet, whether in India or the US, the stock markets too are at their historical highs, as investors remain confident of a pivot by the US Fed later this year or early next year.

However, it is important — as an investor in bonds or stocks — to understand the basics, and exercise caution. First, the two fundamental facts about treasury bonds:

Bond-yields as Economic Barometers: U.S. Treasury bond yields, particularly the 10-year yield, act as indicators of future economic and monetary policy expectations. A rise typically suggests expectations of higher inflation or tighter monetary policy by the Federal Reserve.

Equities and Interest Rates: Higher interest rates (or the expectation thereof) increase the borrowing costs for companies, potentially denting their profitability. Furthermore, the higher yields on risk-free assets like U.S. Treasuries can make them more attractive relative to riskier assets, such as equities, prompting a reallocation of funds.

Given this framework, it’s indeed puzzling when stock markets rally alongside rising bond yields.

Understanding the concurrent rise involves examining a host of intertwined factors:

Economic Growth Expectations: A significant factor behind rising bond yields is the expectation of robust economic growth. Such growth can fuel corporate earnings, and the prospect of higher earnings can boost stock prices. In such scenarios, the optimism about growth can overshadow concerns about higher interest rates.

The Role of the Federal Reserve: Central bank communication plays a pivotal role. If the market perceives the Fed’s stance as supportive—even amidst rising yields—the confidence in the equities market can be sustained. For instance, if the Fed signals that rate hikes will be gradual and linked to concrete economic milestones, it can allay fears of a sudden monetary policy tightening.

Global Capital Flows: In a globalized financial system, capital flows play a significant role. If other major economies are perceived as underperforming or if their monetary policies are more hawkish than the U.S., global funds may continue to flow into U.S. equities, driving up prices.

Sectoral Rotation: Even if the broader market seems to be rallying, there might be underlying sectoral shifts. Growth sectors like tech, which are more interest rate-sensitive, might underperform, while cyclical sectors, which tend to benefit from economic recovery (e.g., financials, industrials), might lead the rally. This rotation can mask the traditional inverse relationship at the aggregate level.

Human Psychology and New Technology

Market movements aren’t solely a product of cold, hard data. Human psychology plays a significant role:

FOMO (Fear of Missing Out): In periods of prolonged rallies, momentum can be self-sustaining as investors jump in to avoid missing out, further driving up stock prices.

Reinterpretation of Data: Market participants are adept at reinterpreting data to fit prevailing narratives. Rising bond yields, traditionally seen as a cautionary sign, might be reframed as a validation of the growth story, further fueling optimism.

Besides human psychology, technology and market structure also plays a part in the current ebullience in the stock market. Two elements in particular are important: Passive Investing, or the rise of index funds and ETFs has led to more automatic, less discretionary investing. Inflows into these funds can drive up stock prices irrespective of changing economic fundamentals.

The second structural element is the rise of stock buybacks by companies that can provide consistent demand for equities, propping up prices. However, to be fair, this is not a big contributor to the current valuations.

Caution

Therefore, investors should remember that while bond yields and stock prices might move together in the short term, the long-term dynamics could revert to the traditional inverse relationship. Secondly, the bond market is managed largely by experts, and therefore considered a surer indicator of what is to come, compared to the stock markets which is seen as more susceptible to emotion and liable to be ‘swept off’ its feet by fads and mania.

It is essential, therefore, for stock investors to distinguish between short-term market dynamics, which can be influenced by sentiment and momentum, and longer-term trends, which are more rooted in fundamental economic realities.

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