Long-term Treasuries have been a lousy place to put your money this spring. That could mean bad things for stocks.
Since bond prices peaked March 22 -- two days after the
third rate cut of the year -- the
Lehman Brothers Treasury Bond Index
has dropped nearly 7%. Meanwhile, the yield on the benchmark 10-year Treasury has swollen by more than a half-point to 5.4%.
What's odd is that this has happened during a period of Fed easing. The
fed funds short-term rate target now stands at 4%, down from 6.5% at the start of the year. Usually, long rates come down when the Fed eases, as it has done five times this year. Market watchers disagree about what this anomaly means -- are investors betting on inflation? -- but most agree that whatever the answer, it's not good for stocks.
That's because higher yields make bonds relatively more attractive to investors, drawing money away from the stock market. Higher bond yields also make borrowing more expensive for consumers and companies, reducing the economic activity that the Fed seeks to encourage by cutting short-term rates. That pressures corporate profits, which are already in retreat but must rebound if stocks are to rise.
"You've got earnings under tremendous pressure, but you've also got bond yields going up," says
equity strategist Doug Cliggott. "That's just a horrible mix for an equity investor. You're getting the negative impact of much slower growth, but you're not getting the typical offset."
Source: Baseline, Yardeni.com
The jump in bond yields is also damaging to equities because it could mute the profits recovery the market is expecting.
One of the key ways that rate cuts bring about economic growth is through lower mortgage rates. As rates come down, many homeowners refinance their mortgages, reducing monthly payments and leaving them with more free cash for other things. But mortgage rates are tied to long-bond yields. Since late March the rate on the average 30-year mortgage has risen by about a half-point to 7.16%. As a result, refinancing activity over the past month has slowed, taking away some of the juice in the economy.
Higher long yields also raise corporate bond yields, making it harder for companies to raise money in the fixed-income arena and increasing the amount of debt service they need to pay when they do. Companies typically draw on the bond market to finance capital-intensive projects. Higher yields could result in reduced capital spending -- another mark against a profits recovery.
The good news is that many observers downplay the worries of inflation, noting other factors that may have made long-dated bonds yields rise. In the wake of the just-passed tax cut, fiscal policy is less restrained than it was, suggesting more issuance of government debt in the future. The Fed has recently shown a willingness to overshoot on rates, leading to speculation that it could be taking back some of its rate cuts by early next year.
The better news is that there are plenty of people who consider the selling in bonds overdone, and expect long yields to come down in short order.
Credit Suisse First Boston
bond strategist Mike Cloherty points out that the market has begun to price in an expectation that the Fed will be raising rates again (after cutting once more at the next meeting) by November. That's a much-too-sanguine view of the speed with which the economy will recover, he says.
But that raises a further question. If the market's recovery expectations are overstated, what can one say about its expectations for profits?