The Most Important Number in Finance
The most keenly watched interest rate in the world is stirring things up.
The 10-year US treasury (10yr UST) yield is arguably the most important number in finance. It is the de-facto global “risk-free” interest rate used in financial calculations across the world (the rate of return that theoretically bears no credit risk).
The chart above shows the steady downward trend that has defined the path of the 10 yr UST yield over the past 36 years.
You can see that as of the end of the week, this yield jumped up to 2.84% – the highest level since 2014.
The 10-year yield is now up 84 basis points since November 2017 – with 40 basis points of that rise having occurred in 2018.
Looking at the chart above, it appears 10yr UST yields have broken above their long-term downtrend, with many market players now looking at 3% as the next line in the sand.
This is possibly the most watched chart in finance at present. 2018 is shaping up to be the year that 1-r UST yields break out of their generational downtrend. Central bank policies have been aggressively suppressing yields ever since the financial crisis. Are we now reaching an inflection point?
10 years bond yields are a function of investors’ expectations for inflation and GDP growth over the long-term. So rising bond yields are a perfectly normal by-product of an economy that is doing well.
However, rising bond yields also exert a tightening influence on the economy. You see, corporate bond yields (the price corporates must pay to borrow money) are priced using a spread over treasury rates. So when treasury yields rise, the borrowing costs for companies will generally rise as well. Higher rates therefore tend to constrain companies from borrowing to invest or grow (or buy back their own shares!).
Rising yields therefore tend to apply the brakes to growth.
Impact on Stocks
Another symptom of rising bond yields is a corresponding sell-off in high yielding stocks. When bond yields are low, investors searching for income will tend to sell bonds and plough that money into dividend stocks. As bond yield rise, those company dividends start to look relatively less attractive and as a result, money will tend to flow out of those stocks and back into bonds.
The two worst performing S&P sectors in recent months are the higher yielding sectors of:
REITs… …and utility stocks:
Stocks with the highest yields have in fact been steadily hammered in recent months, however this dynamic has gone largely unnoticed in a stock market that keeps posting new highs…until last week that is.
The Dow fell 666 points on Friday. What is it about that number, huh? It first made an appearance in the Bible on Revelation 13:18. A very spooky 70s horror movie featured it. Iron Maiden made a popular song about it. And oddly, 666 was the exact low reached by the S&P 500 on 9th March, 2009. So, is Friday’s move on the Dow an ill omen?
Well, last week’s moves certainly got a lot of people wondering if this could be the start of something big.
Bull or Bear Market?
2017 was an exceptionally calm year. A record-breaking year of calmness, with no sell-offs to speak of. Market players have been lulled into such a feeling of complacency that when a sell-off like the one last week comes around, people start wetting themselves unnecessarily.
The S&P 500 posted a GAIN of +5.6% in the month of January – more than we see in an entire year some years. The market has been running very hot for months and a pullback was in order.
Looking at the US economy, the global economy and US earnings – they all remain strong. US GDP growth was +2.6% for the December quarter and +2.5% for 2017. Consumer confidence, consumer spending and home building all remain strong.
Earnings season is progressing very well so far with just over 70% of companies beating earnings estimates.
and the quality of these earnings beats appears sound with 71.6% of companies beating revenue estimates.
Forward guidance from companies is also stronger than it has been at any time this decade.
The recent Trump tax cuts of course helping to provide a decent fillip for US earnings expectations this year.
The underlying theme remains one of growth. I see recent stock market activity then as a sell-off we had to have rather than anything more sinister.
Things to keep an eye on
However there are a couple of important developments I am observing keenly.
The first is the level of 10yr UST yields. If the level of 3% is breached, I expect we’ll see a rapid unwinding of positive sentiment towards equities. This will make the stock market far more difficult in 2018.
The other important factor to keep an eye on is the Fed and the shape of the yield curve.
The Fed is projected to raise interest rates three times this year, with another two hikes predicted for 2019.
Should this transpire, we need to pay careful attention to the shape of the yield curve (please read this article for a primer). The yield curve is a risk I have put a lot of focus on in recent months (see here and here for reference).
An “inversion” of the yield curve occurs when short-term interest rates are higher than long-term interest rates. An inverted yield curve has been a very reliable predictor of recessions and bear markets. I see this as a key risk to my positive view in 2018.
Another risk i want investors to be aware of is high correlation between asset classes.
Normally, stocks and bonds move differently from one another. But what we saw last week was a sharp sell-off in stocks and bonds simultaneously.
The chart above (source: Bloomberg) shows the performance of the S&P500 ETF PLUS the iShares 20+ Year Treasury ETF. This combination suffered its worst sell-off since the dark days of 2009.
There are two key takeaways here:
- If you are sitting comfortably in a “diversified” portfolio, the diversification may not provide you with the protection you expect and need.
- You need to learn how to make money in falling markets. Otherwise, when the next bear market does hit, your portfolio will really suffer.
If you would like to learn more about how to profit in rising AND falling markets and significantly increase the results you’re getting from your current trading efforts, click here to watch my FREE instructional video. Simply enter your name and email for instant access.
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