Largely spooked by rising bond yields, investors continued to dump equities last week, extending early-year losses that caught many off guard because of their speed and severity. Once again, tech stocks were at the forefront. The selloff also widened to include sectors such as banking and energy, sending the S&P 500 to its worst streak of declines since the start of the Covid-19 pandemic.
Underlying much of this movement, analysts say, is not just rising yields on regular US government bonds, but also those on inflation-protected Treasury bills, known as TIPS.
Investors pay particular attention to TIPS yields because they offer an important indicator of financial conditions, indicating whether borrowing costs for businesses and consumers are rising or falling when the effects of expected inflation are removed.
Often referred to as real returns, TIPS returns have been deeply negative since the early days of the Covid-19 pandemic, helping to fuel outsized stock market gains by pushing investors into riskier assets in search of better returns. Even today, they remain below zero, meaning holders are guaranteed to lose money on an inflation-adjusted basis if they hold the bonds to maturity.
Yet they have climbed even more this year than yields on regular Treasuries – a sign of higher borrowing costs for businesses, better forward-looking bond yields and a return to more normal growth and inflation. as the Federal Reserve begins to tighten monetary policy, all of which is generally bad news for the high flyers of the pandemic-era rally.
Investors will get new insight into Fed thinking this week when the central bank holds its first policy meeting of the year. They will also pay close attention to the profits of companies like General Electric Co..
, Johnson & Johnson and Microsoft Corp..
, looking for positive news to reverse multi-week declines in the three major stock indices.
Donald Ellenberger, senior fixed income portfolio manager at Federated Hermes, is among those responsible for the surge in real yields. From the early days of the Covid-19 pandemic, he was a major buyer of TIPS, steadily increasing them from 4% of his multi-sector bond portfolio in March 2020 to 7% in November of the same year.
Mr Ellenberger’s fear at the time was that the historic fiscal and monetary stimulus would lead to soaring inflation – a fear that proved prescient as TIPS rallied and the price index to consumption soared in 2021, climbing 7% in December from a year earlier.
Late last year, however, the Fed changed course, promising to accelerate the reduction of its bond-buying program and begin raising interest rates as early as March. In response, Mr. Ellenberger and his team reduced their TIPS holdings from 7% to 1%.
“If the Fed is no longer willing to tolerate above-trend inflation in hopes of creating full employment for all demographic segments of the population, then the rise in TIPS relative to nominal Treasuries is much less attractive,” he said.
In the past week alone, the tech-heavy Nasdaq Composite Index lost 7.6% and the S&P 500 fell 5.7%, marking their biggest weekly decline since March 2020, while bitcoin tumbled. dropped by 15%. In the bond market, the yield on the benchmark US Treasury stood at 1.747% on Friday, down from 1.771% a week earlier, as nervous investors fled stocks for safer assets. Despite the ripples, 10-year TIPS yields continued to rise, to minus 0.603% from minus 0.708% a week earlier.
Rising Treasury yields aren’t always bad for stocks. In some cases, investors sell bonds, driving up yields, as they anticipate more economic growth and inflation, which could lead to higher interest rates in the future. In this case, actual returns could increase. But nominal yields tend to rise further, and the negative impact of higher borrowing costs may be offset by the better economic outlook, also driving equities higher, as has happened after the past two presidential elections.
This year’s sell-off is in a different category, less supportive of equities, as investors actively prepare for tighter monetary policy and give up their inflation bets.
The difference between the yields of regular and inflation-protected treasury bills is known on Wall Street as the equilibrium inflation rate because TIPS holders are compensated as the price index at consumption rises, ending up with the same return as ordinary Treasury bond holders if annual inflation is the difference between the two returns.
In a 2020 report, BNP Paribas analysts found that a 0.3 percentage point rise in the 10-year breakeven rate was correlated with a 6.6% gain for the S&P 500 and 5. 2% for the Nasdaq. Meanwhile, the report found that a 0.15 percentage point rise in five-year real yields was correlated with a 1.4% drop in the S&P 500 and a 4.2% drop in the Nasdaq. .
For investors, the big concern is where returns go from here, with growing fears that more gains are both likely and likely to fuel further volatility in other assets. Notably, the yield on the five-year Treasury inflation-protected note was still minus 1.204% on Friday, well below the real short-term interest rate of around 0.5% that most policymakers Fed estimated to be the resting level of the economy during the period. run longer.
Many investors remain confident that bonds and equities should stabilize given the strength of the economy and the Fed’s recent cautiousness in normalizing monetary policy.
“The point of a Fed tightening cycle is to slow the economy and the way you do that is to push up real yields,” said Jurrien Timmer, head of global macro at Fidelity Investments. “As long as it’s orderly, which I think has been so far, I think it’ll be fine.”
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Yet there are notable exceptions. Value investor Jeremy Grantham, the co-founder of Boston fund manager Grantham, Mayo, Van Otterloo & Co., which predicted the stock market crashes of 2000 and 2008, said last year that stocks were in a major bubble based on investors’ belief that interest rates would stay around zero forever. Last week, he turned that into a “superbubble” that could end at any time.
In a note posted on GMO’s website, Mr Grantham wrote that it generally makes sense now to avoid US equities, looking for cheaper alternatives in emerging markets and some developed countries, such as Japan.
“I personally also like silver for flexibility, resources for inflation protection, and some gold and silver,” he wrote.
Write to Sam Goldfarb at [email protected]
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