Here are two things that are both true: A stronger economy is generally good for stocks, and a stronger economy means higher Treasury yields. Students of logic don’t have to progress far in their studies to realize that higher Treasury yields are not, therefore, necessarily good for stocks, and if they missed the class they need do no more than glance at last week’s markets.
This past week, bond yields jumped and stocks fell. The trouble was that yields jumped for reasons other than economic optimism, and stocks didn’t like it. Federal Reserve Chairman
used his congressional testimony Tuesday and Wednesday to calm the market, but an unusual spike in yields on Thursday took down stocks nonetheless.
When yields rise because the economy improves, it shouldn’t hurt stocks (the sheer size of Big Tech raises some doubts this time, but leave that for later). Yes, higher yields reduce the value of companies’ longer-term profits, but a stronger economy means more of those profits in the first place.
When yields rise because bondholders are spooked by the size of Treasury auctions, or when upward momentum takes over, or when investors fear a change in approach by the Fed, there’s no offsetting economic improvement to help stocks.
What happened this past week seems to be rising concern that the Fed will keep its foot on the accelerator for too long—and will have to hit the economic brakes hard in the future to tamp down inflation.
At the start of this month, eurodollar futures were priced for the Fed to raise rates from the current range of 0%-0.25% up to 1.5%-1.75% by 2025, and investors were fine with that. This month, the market’s begun to price rates up by another half a percentage point by then, even as rates for the next two years are expected to remain unchanged (as the Fed itself says).
Inflation expectations embedded in the Treasury market for the next five years have risen sharply this month, even as expectations for the five years afterward have fallen. It may seem bizarre to worry about what will happen to inflation in many years’ time, given investors are hopeless at predicting even what will happen next year, but the broad outline suggests rising concern that the Fed is taking it too easy. It is true that the Fed can bring high inflation back under control more easily than it can push up low inflation. But if inflation gets too high, it might have to hit the economy hard to bring prices back under control, and the combination of rising rates and a weaker economy is definitely bad for stocks.
We can be more granular about the impact on stocks than just talking about the overall market, because the split between Big Tech and cheap economically sensitive cyclical companies is so extreme—and because the two parts of the market react so differently to Treasury yields and the economy.
Big Tech and similar growth companies are not very sensitive to the state of the economy, but are very sensitive to changes to bond yields. Cyclical stocks are highly sensitive to the state of the economy, but not much affected by Treasurys. And in both cases, they are both more sensitive than in the past.
We can measure this very simply by comparing Nasdaq stocks, which tend to be growth-oriented, to the S&P 500, which includes many more old-line cyclical stocks.
The link between rising Treasury yields and the outperformance of the S&P is the strongest since at least 1980, with daily changes in yields explaining more than half of the relative performance. Usually changes in yields have little bearing on relative performance.
We ought to see this as a good thing. Just as Big Tech and the Nasdaq did very well even as the economy crumbled, they should underperform or even fall outright as the economy recovers. Exactly this has happened for the FANGs since the start of September.
—as well as
often added to the acronym—are down since then, even as their forecast earnings were upgraded.
née Google, the fourth of the quartet, is up.
The cyclicals offer more near-term growth, while the acronym stocks’ promise of growth far into the future is made less valuable by higher bond yields.
The market is broader, too. Up to Sept. 1, the S&P 500 rose 9% even as more than half of its members fell, because it was the biggest stocks that went up the most. Stocks that beat the market over the period have an average market value of $120 billion, while stocks that have beaten the market since then—about two-thirds of the index, again showing the broadening out—are worth less than half that.
There are two new dangers. First, bond yields might rise even further, without any further strength in the economy to compensate. Second, the market leadership might have switched from cyclicals to speculative stocks, an unlikely mix of electric vehicles, clean energy, cannabis and bitcoin that finds its nexus in
and ARK Investment Chief Executive
If speculative excess ends badly, the fall might drag down much of the rest of the market.
Write to James Mackintosh at [email protected]
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