Hangover, Bond Market Style

Most of the world’s equity traders are starting the year in an upbeat mood. The so-called Santa Claus rally continues into the first two trading days of the New Year, so it is logical to expect some of the holiday buoyancy to continue.^[1]Although much of Asia and the British Commonwealth were closed, European markets set a positive tone that spilled into early US trading. A report of record deliveries from Tesla (TSLA) certainly added to the early high spirits.TSLA is now the 5^th largest component in the market-capitalization-weighted S&P 500 (SPX) and NASDAQ 100 (NDX), so a 10% rally in those shares provides a solid boost to those key indices. Bond traders – who got to leave early on Friday, by the way – began the year with far less enthusiasm. Rates rose, meaning that bond prices declined. It is important for all investors to consider the relationship between stock prices and bond yields – particularly in a year when the latter are widely expected to rise.

As I write this, 2-Year note yields are up nearly 5 basis points (bp) to about 0.78% after briefly touching 0.8%. Yields in the 5 to 30-year range are all up about 10bp, pushing the 10-year to 1.61% and the 30-year above 2%. Rates are higher, and the curve is steepening. It appears that bond traders are expressing concerns either about the tapering of bond purchases by the Federal Reserve or the pace of future inflation. Neither is a promising prospect for bond prices.

Two-year Treasury note yields have been moving steadily higher, a trend that began at the end of the third quarter and continued through today, as the chart below shows:

One Year Chart, Generic 2-Year Note Yields

(Click on image to enlarge)

Source: Bloomberg

The nature of the move and its timing are hardly coincidental. Early last year we saw rates meander in the 10-20 bp range. The Fed was continuing its record pace of monetary stimulus, which suppressed rates. It is clear in hindsight that short-term rates markets failed to recognize that the inflation that would ultimately result a few months later from the combination of fiscal and monetary stimuli. By autumn the mood had shifted. The Fed began discussing tapering its bond purchases and the prospect of rate hikes began to enter the conversation. Concerns began shortly after the September 22^nd FOMC meeting, then accelerated after each of the meetings on November 3^rd and December 15^th. 

Shortly after the December meeting, we asserted that 2-year yields seemed to be testing the veracity of the rate hikes suggested in the Fed’s dot plot. At the time, those rates were about 0.625%. Since then, it appears that note traders are more willing to accept the likelihood that we can see three rate hikes during each of this year and next. Bank stocks are enjoying the rising rates and the steepening yield curve, a relationship we analyzed last month, and a wide range of other stocks are seemingly unconcerned. 

We often hear about how higher long-term rates are detrimental to the valuations of stocks with high P/E multiples, with specific concerns about the most highly valued tech stocks. There is a fundamental logic to that assertion. When rates rise, we must discount the present value of a company’s future earnings and cash flows more aggressively. Higher rates lead to lower present values, which should depress those stock prices.  If this were indeed the case, we would expect to see NDX fall when 10-year rates rose. Yet over the past year we have seen NDX steadily rise even while 10-year rates traded in a fairly wide range:

One Year Chart, Generic 10-Year Yield (blue/white candles, right scale) vs. NDX (blue line, left scale)

(Click on image to enlarge)

Source: Bloomberg

Quite frankly, I don’t buy the assertion that there is a tight link between 10-year yields and the valuation of major tech stocks. Let’s be clear, I am not dismissing the fundamentals of corporate valuation. I most certainly believe that stock prices reflect investor views of the future value of corporate cash flows. But there is another variable that is much harder to model, and that is the multiple that investors are willing to pay for those future flows. Those are highly dependent about investor sentiment. Many of the most highly valued tech stocks do indeed display steadily rising earnings, but they also benefit from investors’ continuing willingness to pay a premium price for a claim on those earnings. In other words, valuations matter, but not as much as investor enthusiasm.

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[1] To be fair, this year’s “Santa Claus” rally was almost completely front-loaded.SPX rose 1.38% on December 27^th, the first trading day after Christmas, then dipped about 0.5% over the rest of last week.