It’s getting harder and harder to quarantine the selloff in Treasuries from equities and corporate bonds.
The benchmark 10-year U.S. yield cracked 2.7 percent on Monday, rising to a point many forecasters weren’t expecting until the final months of 2018. For over a year, range-bound Treasuries helped keep financial markets in a Goldilocks state, with interest rates slowly rising due to favorable forces like stronger global growth and the Federal Reserve spearheading a gradual move away from crisis-era monetary policy.
Yet the start of 2018 caught many investors off guard, with the 10-year yield on pace for its steepest monthly increase since November 2016. Suddenly, they’re confronted with thinking about what yield level could end the good times seen since the presidential election. For many, 3 percent is the breaking point at which corporate financing costs would get too expensive, the equity market would lose its luster and growth momentum would fade.
“We are at a turning point in the psyche of markets,” said Marty Mitchell, a former head government bond trader at Stifel Nicolaus & Co. and now an independent strategist. “A lot of people point to 3 percent on the 10-year as the critical level for stocks,” he said, noting that higher rates signal traders are realizing that quantitative easing policies really are on the way out.
U.S. stocks have set record after record, buoyed by strong corporate earnings, President Donald Trump’s tax cuts and easy U.S. financial conditions. The S&P 500 Index has returned 7 percent this year, once reinvested dividends are taken into account, and the U.S. equity benchmark is already more than 1 percent higher than the level at which a Wall Street strategists’ survey last month predicted it would end 2018.
What often goes unsaid in explaining the equity-market exuberance is that Treasury yields refused to break higher last year. Instead, they remained in the tightest range in a half-century, allowing companies to borrow cheaply and forcing investors to seek out riskier assets to meet return objectives.
In fact, investors had largely been better off owning stocks for fixed income than short-term Treasuries. Not so anymore: two-year Treasuries yield 2.12 percent, compared with the 1.76 percent dividend yield on the S&P 500.
“Around 2.9 or 3 percent on the 10-year is where we begin to run into trouble,” said Peter Tchir, head of macro strategy at Academy Securities Inc. “All of this is about the speed of the adjustment. If we are at 3 percent by the end of this week, I don’t see stocks surviving that very well. And rising yields already make it harder for some dividend stocks to do so well.”
Of course, few expect a move of that magnitude, with bond bulls waiting in the wings for the Treasury-market selloff to lose steam.
High Yield, High Risk
But every day that Treasuries decline makes them look that much better relative to speculative-grade bonds, which have largely been a winning bet over the years as credit spreads compressed to pre-financial crisis levels. The U.S. 10-year yield reaching 3 percent this quarter could wipe out half of the expected returns for a high-yield bond index, according to Marty Fridson, chief investment officer at Lehmann Livian Fridson Advisors.
For now, high-yield investors are in the black. U.S. junk bonds rallied in the first few trading days of the year, toppling some bullish year-end forecasts, on the back of equity gains, rising oil prices, tax reform, strong earnings, muted volatility and a low default rate.
The $3.8 trillion U.S. municipal-bond market is also bracing for pain. So far it has mostly tracked Treasuries, with the 10-year muni-Treasury ratio, a gauge of relative value, hovering around 84 percent, close to where it started the year.
The lower the ratio, the more expensive that state and local securities are compared with their federal counterparts. Or, in other words, yields on munis have resisted rising any faster than those on Treasuries.
As with companies, though, much higher interest rates could saddle state and local government budgets with increased borrowing costs, preventing some from taking steps to shore up their underfunded pension plans.
A 3 percent yield on the 10-year Treasury would “definitely have an influence and could create headwinds for the municipal market,” said Eric Friedland, director of municipal research at Lord Abbett & Co.
And in the market for agency mortgage-backed securities, rising interest rates would slow down prepayments, therefore increase how long the obligations remain outstanding. That, in turn, could spark selling from investors who don’t want that added duration risk.
For now, the focus will be getting through this week, which is full of data and events that could either add to the Treasury selloff or throw cold water on it. Janet Yellen has her final meeting as Federal Reserve chair, the Treasury is set to lift coupon auction sizes for the first time since 2009 and the latest jobs report is expected to show an increase in year-over-year wage growth.
That last part, price pressure, is the missing link for the Treasury market selloff. Until inflation picks up and sends interest rates higher, a risk-asset breakdown likely isn’t imminent, said Stephen Jen, the London-based chief executive of hedge fund Eurizon SLJ Capital Ltd. and a former economist at the International Monetary Fund, World Bank and Fed.
Still, investors should be cautious given elevated asset prices, and the risk that 2018 finally brings a global increase in inflation.
“It’s just a matter of time that we get inflationary pressures,” said Jen. “It’s like you are heating up water. It’s not at the boiling point yet, but it’s getting hotter and hotter.”
— With assistance by Danielle Moran, Zachary Hansen, and Christopher Maloney