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Investors wonder if bond market’s capitulation this week is giving all-clear signal on stock market rally

Bond investors stayed pessimistic on the U.S. economy’s prospects for most of this year as the coronavirus pandemic swept around the world, even as the stock market recovered from its late March lows, but even U.S. Treasury traders are now seeing signs of light at the end of the tunnel, sending yields up sharply this week.

The rise in yields is raising questions among some on Wall Street about what a bearish bond market portends for the stock market’s trajectory in coming weeks, amid worries that the S&P 500 index’s spectacular rally from its March 23 lows is becoming overextended.

Investors mostly suggest rising yields are bullish for equities as bond buyers finally come around to the stock-market’s view that efforts to restart business activity closed down by the pandemic will allow a robust U.S. economic recovery to take hold this year.

Up to this week, the stark divergence between high-flying equities and depressed bond yields was undermining investor faith in a further rise in risk asset prices which have already mounted substantial gains in the past few weeks.

“Something had to give. Either risk assets had it all wrong, or rates were too bearish on the economy. Now it seems the rates market has begun to creak,” said Padhraic Garvey, regional head of research at ING, in an interview, noting the bond-market was last to join in the reflation narrative, with beaten-down emerging market bonds and equities showing inflows last week.

For the week, the Dow Jones Industrial Average DJIA, +3.15% rose 6.8%, the S&P 500 SPX, +2.62% gained 4.9%, while the Nasdaq Composite COMP, +2.06% advanced 3.3% and the Nasdaq-100 NDX, +2.02% rose 2.8%.

The 10-year Treasury note yield TMUBMUSD10Y, 0.901% rose 8.5 basis points Friday to end at a ten-week high of 0.90% on Friday, and may be on its way to hitting the 1% level. At the end of last week, the benchmark’s yield stood at 0.65%, in comparison.

After all, bond investors usually take pride in being better prognosticators on the twists and turns of U.S. economic growth, more so than their eternally cheery counterparts in the equities market. This characterization of savvy bond traders may have taken a hit as expectations for a growth rebound show up across several corners of financial markets.

The stock-bond disconnect in part reflected concerns by Treasury investors as to whether the trillions in financial assistance approved by Congress and the Federal Reserve would be enough to reflate the economy.

The U.S. government has injected some $3 trillion in fiscal stimulus into the economy, while the Federal Reserve’s balance sheet rose to $7.21 trillion as of June 3, amid efforts to mitigate the severity of the economic downturn wrought by business closures to limit COVID-19’s spread. Those measures have been often cited as one of the key reasons behind the stock market recovery from its March 23 lows.

But the May U.S. jobs report from the Labor Department on Friday may have finally ended those worries, offering one of the first data points showing the effectiveness of the stimulus policies, suggesting that the worst of the economic devastation from the COVID-19 pandemic may be over.

The U.S. economy added 2.5 million jobs in May, well above the MarketWatch-polled consensus of 7.25 million job losses, while the unemployment rate fell to 13.3% from a post–World War Two record of 14.7% in April.

“A [jobs] report like this certainly calls that view into question,” Bill Callahan, investment strategist at Schroders, told MarketWatch.

Inflation expectations may also be creeping up as the near term risk of deflation disappears, said Callahan. Based on trading in U.S. Treasury inflation-protected securities, bond investors’ expectations for consumer price rises over the next decade stood at 1.26%, up from 0.50% on March 19.

But higher yields are not necessarily a boon for the stock market.

The two most important drivers of equity returns are the level of bond yields and the pace of corporate earnings growth, Wharton Business School finance professor, Jeremy Siegel, told MarketWatch.

Lower bond yields can enhance the attractiveness of stocks as the returns generated from holding risk-free investments like bonds dwindle. On the flipside, higher yields can make holding Treasurys more appealing. That means stocks have to generate richer returns relative to bonds in order to draw money from investors.

And higher yields can lift borrowing costs at a time when the federal government and companies are taking on increased debt in the wake of the coronavirus pandemic.

Yet history shows that there were far more days when stocks rose along with yields, versus days when stocks rose and yields fell, according to research by Credit Suisse.

That’s because during periods when reflation expectations are gaining ground, stocks have the ability to survive higher yields and so both will often rise with each other, according to Jonathan Golub, chief equity strategist at Credit Suisse.

For next week, investors will focus on the Federal Reserve’s policy meeting on Wednesday when Chairman Jerome Powell will comment on the economy’s prospects and whether further measures are needed to support growth. Traders, in particular, are looking for signs that the central bank may adopt a policy of capping yields for certain maturities, in a strategy known as yield-curve control.

U.S. economic data next week will show the state of inflationary pressures amid the pandemic. May readings for consumer prices, producer prices and import prices could give an indication of how consumers have reined in their spending.

There will be a handful of American companies reporting earnings next week, including AMC Entertainment Holdings Inc. AMC, +9.85%, Tiffany & Co. TIF, +6.51%, and Adobe Inc. ADBE, +1.84%

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