Abstract: U.S. bond yields soared and the stock market was hit by escalating inflation expectations and growing fears about the Fed's imminent plan to tighten its quantitative easing. While investors' outlook for the U.S. economy has improved, it has not helped the stock market significantly and has been a catalyst for Treasury yields to move higher. But yields fell sharply following the issuance of three-year Treasury notes, and consequently the Nasdaq closed the day up nearly 4%, its best gain since last November. Is there room for yields to rise? Why does it have such a big impact on the stock market? How should investors adjust their strategy?
Investors were more optimistic about the U.S. economic recovery, but fear of rising inflation came along as vaccination speeds up and liquidity will result from Biden's upcoming $1.9 trillion stimulus package. The surge in crude oil and commodities may also reflect, in part, rising expectations of future inflation. And normally, bond yields and inflation go hand in hand. On the one hand, higher inflation will reduce the purchasing power of bond investors' future returns. On the other hand, bond investors are more inclined to sell their risk free assets -- U.S. Treasurys -- because they expect higher inflation may partly reflect a stronger economy in the future, reducing demand for bonds and pushing bond yields higher.
In addition, as an accelerator of rising Treasury yields, the U.S. Senate recently passed Joe Biden's $1.9 trillion economic stimulus package, thus fueling the market's stronger inflation expectations as the government increased liquidity on a large scale. As a result, yields moved, climbing to 1.6% on the 10-year Treasury bonds and 2.3% on the 30-year, nearing pre-outbreak levels. What does the rise have to do with the stock market?
Better economic expectations are usually good for stocks, as investors tend to offset inflation by dumping safe-haven U.S. bonds and loading up on stocks and commodities. Depending on supply and demand, yields on Treasuries will also rise as demand falls. As a result, both the government and companies face financing difficulties as their borrowing costs rise, hurting the economy. If the dividend yield of the U.S. stocks is lower than or similar to the yield of the U.S. bond, then investors are more inclined to flow capital into the bond market to seek risk-free return. This will undoubtedly have an impact on the stock market.
Moreover, the market is spooked not just by future inflation expectations, but also by prediction of what the Fed will respond to inflation. The central bank would buy more Treasury bonds to increase demand for them and drive down yields, if it intended to remain easing monetary policy. However, the remarks of Fed Chairman Jerome Powell did not reveal what action will be taken in response to the higher yields of U.S. bonds, so investors are more concerned about the monetary policy, which has also become an important factor in the US stock market decline.
Since the outbreak of COVID-19, the U.S. economy has fallen into the great recession, but it is in the middle and early stages of recovery with rising inflation and slowly improving unemployment. It means that the rise in inflation seems an inevitable part of a full economic recovery. And because the U.S. unemployment rate remains high and small/medium-sized enterprises did not recover from the shock of the pandemic, the Fed may not tighten its quantitative easing in the short term as feared by the market, and the massive economic stimulus will still provide an easing environment and continues to be a bullish force for the US stock market. It's worth noting, however, that the surge in U.S. bond yields may make investors, who are more rational than they were in the previous overheated stock market, more inclined to seek instinct value for their assets. Therefore, value stocks may be more favored in the future.
The S&P 500 climbed to its all-time high of 3,963 in mid-February, and then experienced a six-day losing streak that formed a bearish engulfed pattern on February 25, followed by a break below its 50-day moving average. Despite a strong start to March, the S&P 500 fell further as the massive stimulus package failed to offset fears that Treasury yields were rising, as shown below:
Source from: Mitrade
As a main reason for the S&P 500's weakness, its heavily-weighted tech stocks underperformed. But the tech stocks rallied after Treasury yields fell slightly in recent days, which also helped the S&P 500 and Nasdaq bounce back. Going forward, the S&P 500 may continue to rise in turmoil.
Taken together, Treasury yields have fallen a bit, but this may be temporary. In the long run, faster economic recovery in the United States will certainly be accompanied by increased inflation, and yields may continue to rise. Therefore, investors should be alert to the impact of a short-term spike in Treasury yields on the bullish sentiment, while paying attention to the investment opportunities brought by its short-term volatility.
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