Take Route Fueled by Bond-Market Turns

Scared in large part by rising bond yields, investors continued to dump stocks last week, amplifying early-year losses that let many off guard with their speed and seriousness. Tech stocks were at the fore once again. Selling was also broadened to include sectors such as banking and energy, sending the S&P 500 to its worst position since the start of the Covid-19 pandemic.

Underlying most of these moves, according to analysts: rising yields not only on ordinary US government bonds but also on inflation-protected treasuries, known as TIPS.

Investors pay close attention to returns on TIPS because they provide an important gauge of financial conditions, showing whether borrowing costs for businesses and consumers are rising or falling while isolating the effects of expected inflation.

Often referred to as real returns, the return on TIPS has been very negative since the early days of the COVID-19 pandemic, helping drive 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 bond to maturity.

Yet they have climbed even higher this year than returns on general treasuries — higher borrowing costs for businesses, better-looking returns on bonds, and more normal growth and a sign of a return to inflation, as the Federal Reserve tightens monetary policy. All of which is generally bad news for the high fliers of the pandemic-era rally.

Investors will gain new insight into the Fed’s thinking this week when the central bank holds its first policy meeting of the year. They may also be looking at corporate earnings from the likes of General Electric Co., Johnson & Johnson and Microsoft Corp., looking for positive news to reverse multiweek declines for all three major stock indexes.

Donald Ellenberger, a senior fixed-income portfolio manager at Federated Hermes, is among those responsible for raising real yields. In the early days of the COVID-19 pandemic, he was a major buyer of TIPS, steadily increasing them from 4% of his multisector bond portfolio in March 2020 to 7% by November that year.

Mr Ellenberger’s concern at the time was that historical fiscal and monetary stimulus would lead to an increase in inflation – a fear that proved prescription and the consumer-price index in 2021 climbed 7% in December from a year earlier.

By the end of last year, however, the Fed had shifted course, accelerating wind of its bond-buying program and promising to raise interest rates as soon as March. In response, Mr. Eilenberger and his team reduced their TIPS holdings from 7% to 1%.

“If the Fed is not prepared to tolerate upward-trend inflation in hopes of creating full employment for all demographic segments of the population, the upside to TIPS relative to nominal Treasuries is much less attractive,” he said.

Last week alone, the tech-heavy Nasdaq Composite Index lost 7.6% and the S&P 500 lost 5.7% – marking their biggest weekly drop since March 2020 – while bitcoin fell 15%. In the bond market, the yield on the benchmark US Treasury note fell to 1.747% on Friday, up from 1.771% a week ago, as panicked investors fled stocks for safer assets. Despite the crosscurrents, the 10-year TIPS yield continued to rise – from minus 0.708% a week ago to minus 0.603%.

Rising Treasury yields aren’t always bad for stocks. In some cases, investors sell bonds — pushing yields higher — because they anticipate greater economic growth and inflation, potentially leading to higher interest rates down the road. In that case, the actual yield may increase. But nominal yields rise higher, and the negative impact from rising borrowing costs could be overwhelmed by an improved economic outlook, causing stocks to climb too — as it did after the last two presidential elections.

This year’s selloff belongs to a different category, which is less favorable for stocks, with investors actively preparing for tighter monetary policy and pulling back on their inflation bets.

The gap between normal and inflation-protected Treasury yields on Wall Street is referred to as the break-even inflation rate because holders of TIPS are compensated as the consumer-price index rises, returning similar returns to holders of normal Treasuries. If the annual inflation matches the difference between the two yields.

In a 2020 report, analysts at BNP Paribas found that a 0.3 percentage-point increase in the 10-year break-even rate was correlated with a 6.6% gain in the S&P 500 and 5.2% for the Nasdaq. At the same time, the report found that a 0.15-percentage-point increase in five-year real yields was correlated with a 1.4% decline in the S&P 500 and a 4.2% decline in the Nasdaq.

For investors, the bigger concern is where the returns go from here, with fears that higher gains are potential and likely to fuel further volatility in other assets. Notably, the yield on the five-year Treasury inflation-protected security was minus 1.204% on Friday, well below the roughly 0.5% real short-term interest rate that most Fed officials estimate as a measure of comfort for the economy. should be level. long run.

Many investors are confident that both bonds and stocks should stabilize, given the recent record of the economy’s strength and the Fed’s caution while normalizing monetary policy.

“The whole point of the Fed’s tightening cycle is to slow the economy down and the way you do that is to push real yields higher,” said Jurienne Timmer, director of global macro at Fidelity Investments. “As long as it’s settled, which I think overall so far, I think it’ll be fine.”

Nevertheless, there are notable exceptions. Value investor Jeremy Grantham, co-founder of Boston money manager Grantham, Mayo, Van Otterloo & Co., which predicted the market declines of 2000 and 2008, said last year that stocks based on confidence among investors could have a big advantage. were in a bubble. Interest rates will be around zero forever. Last week, he upgraded it to a “Superbubble” that could end at any moment.

In a note posted on the GMO’s website, Mr. Grantham wrote that it now generally makes sense to avoid US stocks, while looking for cheaper alternatives in emerging markets and some developed countries, such as Japan.

“Personally speaking, I like some cash for flexibility, some resources for inflation protection, as well as a little gold and silver,” he wrote.

This story has been published without modification to the text from a wire agency feed