Bond prices have experienced a decline recently due to mounting fears of inflation. However, stock prices have managed to stay strong amidst these concerns.
Longer Period of High Interest Rates Expected
There are indications that the Federal Reserve might need to maintain high interest rates for a longer duration than initially anticipated in order to control inflation. As a result, bond yields are increasing while bond prices are conversely falling. The rise in interest rates is unfavorable for the stock market as well. Nonetheless, equity investors are optimistic that corporate earnings will strengthen in the latter part of 2023 and throughout 2024.
Growing Trepidation in Bond Market
In recent times, the 10-year Treasury yield has climbed slightly above 4%, compared to approximately 3.7% at the end of June. Despite the Federal Reserve’s efforts to cool down the economy by implementing a series of rapid interest-rate hikes last year, the labor market remains robust. Consequently, it is possible that the central bank may need to initiate one or more additional rate hikes.
Bonds, which experienced a significant slump when the Federal Reserve began its campaign of increasing rates, are once again causing concern. The MOVE Index, which measures volatility in the bond market, has reached its highest level in months.
Implications of Inflation on Bond Market
Perhaps the most alarming aspect is that the bond market is signaling an expectation of further inflation and the need for sustained high interest rates. Average annual inflation expectations for the next decade, as reflected by the inflation swaps market, have risen from approximately 2.18% in late June to around 2.27%. Furthermore, the 10-year yield currently stands approximately 1.75 percentage points above inflation expectations, compared to roughly 1.53 points at the end of June. The widening gap between bond yields and inflation expectations indicates that bond traders perceive a high probability of inflation expectations continuing to rise slowly but steadily.
The Current State of the Stock Market
At present, rising interest rates may indicate a negative outlook for the economy and corporate profits. Despite this, the S&P 500 stock index has shown resilience, increasing over 20% since its low point in early October. Surprisingly, the index has even managed to make modest gains since the end of June when yields began to climb.
However, stocks now face growing risks. Continued economic demand destruction could potentially lead to a decline in earnings, causing stock valuations to become even more expensive. Currently, the S&P 500’s forward price/earnings ratio stands at 19 times, resulting in a 5.2% earnings yield. Unfortunately, this yield is only about 1.2 percentage points higher than the yield of a safe 10-year bond. Such a small margin indicates a lower-than-normal risk premium for equities. In order for stocks to thrive, two potential developments must occur: either earnings must experience rapid growth, or interest rates must decline. Ideally, both scenarios would unfold.
Mike Wilson, the chief U.S. equity strategist at Morgan Stanley, wrote, “The market seems to be saying it doesn’t care about the near-term earnings recession because the second half of 2023 and 2024 are going to be so strong.” This optimistic outlook suggests that the market believes in a robust recovery ahead.
Additionally, Tom Essay from Sevens Report argues that the stock market expects rates to decrease going forward. This implies that there is a consensus around future rate adjustments.
While the market may be correct about both earnings growth and rate changes in the long term, it is likely that the road ahead will be challenging and unpredictable.