There is a conundrum at the heart of US financial markets right now, it seems. Bond market fears are reaching fever pitch, catapulting Treasury yields to their highest levels in at least 20 years, yet the Nasdaq and S&P 500 are hitting record peaks. What gives?
Investors could be forgiven for doing a double take. Boosted by the frenzied optimism around the AI-driven corporate profit outlook, the S&P 500 is up around 15% and the Nasdaq is up almost 20% this calendar year, even though the benchmark 10-year yield has spiked 120 basis points and the yield on ultra-long US bonds is at a 24-year high.
Soaring borrowing costs and a higher discount rate are typically red flags for stocks.
Indeed, history shows that the rising cost of money almost always plays a significant role in severe economic and financial downturns, recessions, and market crashes. So equity investors have reason to be very cautious, especially given the market's historic concentration in a handful of artificial intelligence and tech stocks.
THE ‘WHY’ MATTERS
But it's important to ask why bond yields are spiking.
The last time yields moved this much was in 2022 when the Federal Reserve cranked up interest rates aggressively to tackle the post-lockdown inflation whoosh that was then amplified by Russia's invasion of Ukraine. The 10-year yield leaped an eye-popping 235 basis points that year, and the S&P 500 slumped 20%.
Back then, sky-high inflation was the big concern.
That doesn’t appear to be the case this time around, although inflation is still above target. If Treasuries were being trounced primarily because of inflation indignation or even fiscal fears, one might expect to see a steeper yield curve and a spike in market-based inflation expectations. Neither has materialized. Breakeven inflation rates on five- and 10-year Treasury Inflation-Protected Securities (TIPS) are comfortably below their peaks from May, and the difference between short- and longer-dated yields has shrunk across most parts of the curve this year.
Instead, the primary driver of the rise in bond yields appears to be inflation-adjusted "real" yields, a sign that investors are pricing in strong real growth.
As Cullen Roche, founder and CIO at Discipline Funds, put it, "The bond vigilantes keep showing up expecting a funeral, but it turns out they walked into a growth party.”
And if bond yields continue to remain elevated because of robust growth projections and not spiking inflation expectations or other risks, Wall Street could keep on dancing.
WATCH THE TERM PREMIUM
The divergence between Wall Street and Treasuries is so extreme that many fund managers say it is time to buy bonds. According to Bank of America, the 10-year rolling return for Treasuries with a maturity of 15 years or more fell to negative 2% last month. That's the worst return in more than a century.
And right now, investors can lock in real, inflation-adjusted yields of nearly 3% over the next decade, and 3.5% over the next three decades. These are generationally high, essentially guaranteed rates of return.
Will this pull capital away from equities? Perhaps, but investors seeking to build a more balanced portfolio may not have better opportunities to do so.
One major threat remains for both bonds and stocks: the term premium. That’s the amorphous degree of extra risk compensation bond buyers demand for buying longer-term debt instead of short-term paper. Sharp, upward spikes in the term premium suggest factors other than growth and inflation, such as doubts around central bank credibility or debt debasement fears, are driving yields higher.
The 10-year US term premium this week has snapped to a new 12-year high of 96 basis points, according to the New York Fed's closely watched Adrian, Crump, and Moench (ACM) model.
It's never clear what is driving the term premium at any particular time, or the ripple effect it will have across markets. But if it continues rising, Wall Street’s party could soon be over.
The opinions expressed here are those of the author, a columnist for Reuters.
