Bond yields hit new highs, pressuring S&P 500

The US bond bear market continues, but with risks for the S&P 500. Notable selling of US Treasuries at the long end of the yield curve is caused by several factors equity and bond investors can no longer ignore, according to Josh Cannington, a StoneX interest rates analyst. While this eventually makes Treasuries and the US dollar increasingly attractive to new investors, a higher discount rate erodes equity market valuation.

Cannington lists the negative factors stacking up for bond markets:

• Government deficits showing no signs of improving, generating a flood of new Treasury supply coming to the market for years to come
• The Fitch downgrade of US debt in August was mainly caused by the absence of political will to deal with the main drivers of the deficit, as well as the continued threat of a government shutdown
• Large Treasury buyers are disappearing, such as the Fed at home, unwinding its program to buy bonds, and China and Japan abroad reducing US bond holdings
• Foreign bond markets, notably Japan, are looking more attractive as yield rise
• And, perhaps most importantly, the market is coming around to the idea that the Fed is serious about its “higher for longer” official interest rate message

US Budget Deficit

Source: Bloomberg, StoneX

Bond yields hit decade highs

We have seen a remarkable rise in bond yields in the past few weeks and a significant bear market in bond prices. Two-year yields trading at 5.22% is the highest point in roughly 17 years and close to the highest in 23 years. Five- and ten-year yields are at 16-year highs, at 4.93% and 4.9%, respectively.

US Treasury yields

Source: Bloomberg, StoneX

Fed chairman Jerome Powell likely welcomes this bearish steepening of the yield curve. It’s been a significant factor in tightening financial conditions, doing much of his work in preference to raising official short rates. Several Fed Presidents and Governors have recently echoed this point:

Christopher Waller, Federal Reserve member: “I believe we can hold the policy rate steady and let the economy evolve in the desired manner.”

John Williams, President of the New York Fed: “My current assessment is that we are at, or near, the peak level of the target range for the federal funds rate.”

Patrick Harker, President of the Philadelphia Fed: “I believe that we are at the point where we can hold rates where they are.”

Bonds look more attractive than equities

Cannington argues that higher bond yields look more attractive than equity yields.  “Not only are nominal bond yields getting attention, but for the first time since 2010, the bond market is offering higher relative returns for investors than their equity counterparts,” he points out. The yield on investment grade ‘AAA’-rated corporate bonds, at 5.45%, is higher than the earnings yield on the S&P 500 index, at 4.67%.

This seventy-eight basis point gap was last seen in 2004. “Textbooks suggest that investors in equities should demand an extra risk premium of several percentage points above risk-free rates in their earnings yield to compensate them for the higher risk of owning stocks over bonds,” Cannington adds.

S&P 500 Earnings Yield versus Investment-grade Corporate Bond Yields

Source: Bloomberg, StoneX

So, what does this mean for markets? Cannington points out that it could mean that Treasuries are overvalued, trading near a top at current levels, or it could mean nothing at all, “like in the 1990s when this spread was in the bond market’s favor for much of the decade,” he adds. There is no definitive answer for where bond yields might end up.

What happens next for the equity market depends to some extent on how the economy, specifically the corporate sector, responds. If the economy slows, top-line revenue growth and profits will inevitably slow. There are some signs that corporate growth is already slowing. For Q3 2023, Factset reports that the annual revenue and earnings growth rate for the S&P 500 was 1.9% and 0.4%, respectively. After several years of solid growth, this is poor.

Bond yields will eventually rise to levels that offer a more compelling story than the return from equities. Cannington concludes: “In each period when bonds offered investors higher returns with less risk than equities, funds flowed in that direction, and in the months that followed, bond yields retraced lower on the back of this uptick in demand.”

This suggests a market outlook where bond markets rally, with declining yields, while equity markets fall. That’s a very different picture from what most investors anticipate today.

Analysis by Josh Cannington, Vice President, Interest Rate Derivatives. josh.cannington@stonex.com

Reported by Paul Walton, Financial Writer: Paul.Walton@StoneX.com