Rates Tantrum Is Stock-Market Bullish to Those Aware of History

(Bloomberg) -- The week-long spike in Treasury yields sparked a tantrum in stocks that has gotten a lot of attention. But to a contingent of bulls with history on their side, the story’s simple: The bond selloff, if anything, points to a still-perky economic backdrop that’s almost always been great for equities.

“It’s a manifestation of the idea that the economy is picking up steam,” Art Hogan, chief strategist at National Securities, said by phone. “Rising yields don’t have to derail the bull market -- especially if they’re rising for the right reasons.”

Rates took off about 18 hours after the Federal Reserve signaled it’s edging closer to winding down pandemic-era bond buying as labor markets continue to tighten and any slowdown from the effects of the delta variant start to ebb. Economists surveyed by Bloomberg still expect gross domestic product to jump 5.9% in 2021 and 4.2% next year. Corporate profits are expected to surge 28% in the third quarter.

In the past 35 years, growth on par with what’s expected in 2022 never came coincided with bad years for equities. And in all the rolling 12 months periods over the last 30 years where the 10-year yield has climbed 50 basis points or more, stocks have advanced, Sebastien Page, multi-asset strategist at T Rowe Price, said earlier this year.

Jim Paulsen, chief investment strategist at the Leuthold Group, says that economic backdrop is what is causing bonds to sag, leading to rate increases that aren’t nearly as challenging for stocks as they might be in slower-growth environments. 

“A 30-basis point rise on a 6% growing economy with solidly double-digit profit growth, that type of growth, that type of fundamental leverage in the economy and companies can offset a lot of problems for the stock market,” he said by phone.

The bond selloff can be traced to a climb in so-called real yields, which strip out inflationary effects and are often viewed as a bond-market proxy of growth expectations. While still deeply negative, 10-year real rates have climbed nearly 20 basis points so far in September, the biggest monthly jump since February. 

“This rate rise so far has been all about real yields rising, which means that the 10-year is not going up because people are getting more frightened by higher inflation -- it’s going up because the bond market’s reflecting stronger real growth,” said Paulsen. 

After trending sideways for months, 10-year Treasury yields broke through the top of a range that had held since mid-July, climbing above 1.55% at one point this week. The speed of the rise spooked some corners of the stock market, notably richly valued tech companies whose future profits are less valuable when rates advance. Tech’s outsize weighting in the S&P 500 has dragged the index lower for the week. 

An argument can also be made that a rethink of Fed policy is behind the spike in yields, a scenario that includes the potential for much-earlier-than-expected rate hikes by the central bank that could derail the expansion. Overnight swap rates now suggest that traders expect the Fed to raise borrowing costs as soon as September of next year. 

But U.S. economic data has been improving of late, according to Neil Dutta, head of economics at Renaissance Macro Research. He cites a string of positive data surprises for August, including home sales, housing construction and business investment. Plus, he says, consumer spending has been strong for much of September. Bureau of Economic Analysis data on payment cards transactions shows consumer spending was up 15% for the week ending September 21 versus the same pre-pandemic period.

Others, including Aneta Markowska, chief financial economist at Jefferies, also point to improving Covid trends. A proprietary model of hers that uses inputs including restaurant bookings and domestic and international flights has been improving in recent days amid a steep decline in delta cases and the expiration of enhanced unemployment benefits, she wrote in a note. This is the beginning of the third stage of the reopening, she said, which could extend through the holiday season and create a pickup in growth momentum in into the new year. 

Even with this month’s climb to minus 84 basis points, 10-year real yields are still well below March’s peak of minus 59 basis points. But it’s the rate of change that might rattle risk assets more so than the absolute level, said Chris Zaccarelli, chief investment officer at Independent Advisor Alliance. 

“I don’t think 1.5% on a 10-year is any reason to be concerned, and you’ve seen that level previously, without any issues,” he said. 

Over the last year, stocks have tended to perform well on days when yields on 10-year Treasuries also rose. They’ve also typically gained when real rates as well as inflation expectations were rising, according to data from Credit Suisse compiled by Jonathan Golub and Manish Bangard. That means the recent selloff on higher rates is atypical, Golub said by email. 

Financials and energy stocks can benefit the most in this environment, as can companies in the materials and industrials sectors, said Hogan at National Securities. 

“Yields for most of this year have been like a beach ball being held under water -- and they’re finally getting out and getting to a level they should be,” he said. “They’re normalizing and I think that that is an expression of the fact that the economy is doing better, and if the economy’s doing better, then the economically sensitive cyclicals sectors likely will do better as well.”

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