Slight Decline On Tuesday

The stock market was down slightly on Tuesday as the S&P 500 was down 0.68% and the Dow was down 0.78%. The Dow ended its streak of 8 straight up days. The Russell 2000 was actually flat after it underperformed Monday. The sector performances show the main action on the day was the reflation trade as long bond yields rose due to increased inflation and growth expectations. Energy and the financials were the best performing sectors as energy was up 0.01% and the financials were down 0.16%. The worst sectors were real estate and healthcare which were down 1.67% and 1.29% respectively. We haven’t seen much weakness in housing related to increasing interest rates.

Rising Yields Won’t Hurt Stocks

I’ve already discussed that stocks won’t necessarily decline when yields rise. It’s not as if the 10 year will hit 5% or even 4% anytime soon. It’s very disingenuous to spark fear because the 3 month yield is higher than the S&P 500’s dividend yield. Firstly, buybacks are more popular than they were in previous cycles, so dividends aren’t the only way capital is returned to shareholders. Therefore, it’s better to look at the earnings yield than the dividend yield. Secondly, the 3 month yield was much higher than the dividend yield in the past when interest rates were higher. There will be declines in the dividend stocks, but that doesn’t mean the whole market will fall.

The chart below shows the recent relationship between the weekly change in the 10 year bond yield and the weekly change in the MSCI world index. As you can see from the chart on the left, there has been no correlation between the two since the November 2016 election. Yields have risen and stocks have risen. There might be a point where rising yields hurt stocks, but we aren’t there yet. For retail investors looking to earn money in their retirement accounts, getting 2.57% on the 2 year treasury isn’t going to prevent them from investing in equities which could provide double digit returns. The headlines today are very disingenuous as they claim stocks fell because interest rates rose. They are as ridiculous as the joke chart on the right showing a vomiting flamingo. The headline writers will completely forget the idea that yields cause stocks to fall if stocks rally tomorrow as yields increase.

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10 Year Yield Spikes To Highest Since July 2011

The 2 year yield increased 2.7 basis points to the highest point of this business cycle. The 10 year yield spiked 6.99 basis points to 3.07%. At one point in the day, the 10 year yield touched 3.09% which is the highest point since July 2011. This all ties into the thesis that economic growth is accelerating and the inflation rate is increasing modestly. If growth is improving more than inflation, it’s for stocks, not a catalyst for them to fall. Since we always look at real GDP, that tells us if growth is surpassing inflation.

Breakeven Curve Near An Inversion

The latest difference between the 10 year yield and the 2 year yield is 50 basis points as there has been a sharp steepening of the curve in the past 2 days. Some investors surprisingly think the curve won’t invert despite the fact that it has inverted prior to the past 5 recessions. At some point there will be a recession, so I don’t think the prediction concludes that there will never be one. The premise of the thesis that there won’t be an inversion is that the fiscal stimulus from the tax cut will cause more inflation now and in the future.

To be clear, this hasn’t been playing out as the 30 year breakeven inflation rate has been increasing less than the 5 year breakeven rate. The chart below shows the difference between the two has fallen from 1% in 2010 to about 0.10%. The breakeven curve has been flat-lining showing inflation estimates for the future aren’t moving up. Yield curve inversions occur when investors think the Fed will start tightening rates to improve the economy. As the Fed tightens rates, the short dated bonds see their yields decline, steepening the curve.

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10 Year Bond Extremely Oversold

One point that supports the notion that the yield curve will invert this year is seen in the chart below. It shows the net speculative position in the 10 year treasury bond as a percentage of open interest. The blue line shows the slightly misleading net speculative position which I often show in articles. Both indicators show the short position in the 10 year bond is very high, meaning yields could fall if this trade unwinds. The percentage indicator is better because it accounts for the increase in trading in the 10 year futures market. Any reversal would potentially invert the curve if the 2 year yield stays steady. There still needs to be a catalyst to push yields lower. It may take until the next economic slowdown which might not happen for a while as this current slowdown appears to be about to end soon.

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Yield Curve Inversion Among Long Bonds

I often focus on the difference between the short end of the curve and the long end of the curve. The Fed manipulates the short end by rate hikes/cuts. The 2 year yield will likely move higher as the Fed raises rates 50-75 basis points by the end of the year. However, the recent flattening hasn’t been exclusive to the short end versus the long end.

As you can see in the chart below, the 30 year yield minus the 10 year yield has recently declined sharply. It was at 80 basis points in early 2016 and now it’s only at 13 basis points. The expected inflation and growth in the next 10 years has increased relative to the next 30 years. The entire curve is flattening. It will be interesting to see which part inverts first. Clearly, this part is flatter than the difference between the 10 year yield and the 2 year yield.

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