Optimism for an economic recovery is rising after a year of coronavirus-induced misery.
But expectations of stronger growth – as well as the higher inflation that could accompany it – are pushing interest rates up, forcing investors to re-examine their valuation of stocks, bonds and any other investment.
When trying to determine the value of anything from Apple stocks to a junk bond, the financial world begins by comparing it to a US Treasury bond, which the government uses to borrow money. For years, yields have been ultra-low on Treasuries, which means investors have very little interest in owning them.
This in turn helped make stocks and other investments more attractive, pushing their prices up. But when Treasury yields rise, the downward pressure on the prices of other investments also increases.
All eyes have been on the yield on the 10-year Treasury bill, which topped 1.50% this week after starting the year around 0.90%. Here’s a look at why the move rocked the financial world, including the worst week for the Nasdaq composite since October:
Part of the reason is rising expectations for inflation, perhaps a bond investor’s worst enemy. Inflation means that future bond payments won’t buy as many bananas, tuition minutes, or anything that goes up in price. Thus, bond prices tend to fall when inflation expectations rise, causing their yields to rise.
Yields on treasury bills also often follow expectations of a strong economy, which are on the rise. When the economy is healthy, investors feel less of a need to own treasury bills, which are considered the safest investment possible.
Hopefully the coronavirus vaccines will buzz savings this year, as people feel comfortable going back to stores, businesses reopen, and workers find jobs. The International Monetary Fund expects the global economy to grow 5.5% this year, after falling 3.5% last year.
A stronger economy often coincides with higher inflation, although it has generally been on a downward trend for decades. Congress is also poised to inject an additional $ 1.9 trillion into the US economy, which could further stimulate growth and inflation.
When trying to determine what the price of a stock should be, investors often look at two things: how much money the company will generate and how much to pay for each US $ 1 of that money. When interest rates are low and bonds pay little, investors are willing to pay more for this second part. Consider a stock like Apple or some other big tech company, which is likely to continue to generate large amounts of cash for many years to come. It’s better to wait a long time if a 10-year Treasury pays less in the meantime.
The recent surge in yields is forcing investors to reduce the amount they are willing to spend for every dollar in the company’s future profits. Stocks with higher prices relative to earnings are hit hard, as are stocks that have been offered for their expected earnings in the distant future. Big tech stocks can be found in these two camps. Dividend-paying stocks are also affected as income-seeking investors can now turn to bonds, which are safer investments.
The ultimate worry is that inflation will take off at some point, sending rates much higher.
Even at 1.5%, the 10-year Treasury yield is still below the 2.6% level it was two years ago or the 5% level two decades ago.
âThe problem isn’t that the 10-year is 1.5%,â said Yung-Yu Ma, chief investment strategist at BMO Wealth Management. “It’s that it went from 1.0% to 1.5% in a few weeks, and what does that mean for the rest of 2021.”
Ma thinks it could continue to rise above 2% by the end of the year, but he doesn’t think it will revert to the old normal of 4% or 5%, which would require an even greater reassessment of the markets. Until it becomes clearer, however, he says he’s looking to keep the stock market volatile.
And yes, stocks are still very high.
Despite the recent market pullback, major US stock indices remain close to all-time highs set earlier this month. The benchmark S&P 500 and the Nasdaq each hit all-time highs on February 12. The Dow Jones Industrial Average set a record on Wednesday. And the Russell 2000 Small Business Index hit an all-time high on February 9.
The US Federal Reserve has direct control over short-term interest rates, and President Jerome Powell told Congress last week he was in no rush to raise them. Powell told Congress that while price increases may accelerate in the coming months, those increases should be temporary and not a sign of long-term inflation threats.
Many investors agree with Powell and expect inflationary pressures to be only temporary.