Treasury yields are on the move. Over the few days, the 10-Year yield has jumped, taking it above the psychologically important 1.5% level. What, if anything, does that mean for investors?
For most investors, bonds and bond yields are confusing. For starters, yields move in the opposite direction to price, and yet it is the yield that is normally quoted in the financial media. Thus, when a move “up” is reported in Treasuries, it actually indicates selling, and vice versa. Then there is what to make of moves in those instruments. Do they mean anything? If they do, are rising yields a good sign, or a bad one? Even more confusingly, the answers to those questions are different right now than they have been for decades and depend on the makeup of your stock holdings.
In the past, the relationship was fairly easy to understand, and had clear indications for stock prices. Yields and stocks generally moved in tandem. A sustained, significant move up in yields, indicating as the selling of Treasuries, was seen as a positive sign for stocks, while a move down was a warning of impending volatility. That was because Treasuries were the “safe” investment for big money as opposed to the higher-risk, higher-return nature of stocks. When things looked good, big funds were prepared to take on more risk and sold bonds to buy stocks, pushing yields up. When they looked bad, money fled to the safety of bonds, pushing yields down.
The mechanics of that are a bit convoluted, but the message was simple: If bond yields were moving up, buy stocks. If they were falling, move to a more defensive portfolio.
Over the past few years, though, that relationship has changed.
When the recession hit in 2008/9, the Fed, along with other central banks around the world, cut interest rates to record lows, while simultaneously injecting cash into the banking system by buying bonds in the open market. Hindsight suggests that that was needed and had the desired effect in terms of aiding the recovery and stabilizing the banking system, but central bank intervention at that level inevitably distorted the market for bonds. When everyone knows that a buyer with the ability to just create money, so who therefore has unlimited funds, is in the market every day, prices are set based without much regard to economic fundamentals.
Prices and yields therefore tell us nothing, or at least something other than they have in the past. A move in Treasury yields now could still be saying something about big money’s attitude to risk, but it is more likely to be about traders’ views on the Fed’s future actions than anything else. A move up in yields could therefore be in anticipation of a rate hike, which would be bad for stocks, rather than any indication of increasing risk appetite.
So, what are we to make of the spike in yields over the last few days?
First, let’s not get carried away. 1.5% is still way below historical averages, and around half the levels seen just three years ago. This is not an earth-shattering move. Also, because it is in response to expectations about Fed actions rather than economic outlook, it is not something that should be seen as an indicator for overall stock pricing. That, however, doesn’t mean it can be ignored.
In this case, the reason for the move is known, so we don’t need to speculate on that and respond accordingly. What investors should be concentrating on is not what is causing the move, but what it will cause. What will higher rates mean for stocks in different styles and sectors?
The extended period of ultra-low interest rates has arguably been the savior of a wounded economy, but it has resulted in much more sensitivity to rates among some companies. They have, understandably enough, taken advantage of all that cheap money and borrowed extensively to expand, or to buy back stock, or for whatever reason. With the 10-Year at 1.25% or below that isn’t a problem, but should they get to 2% or higher, it could quickly become one. Refinancing and rolling over loans is not so easy when rates are double what they were when you originally borrowed.
That is why you are seeing the weakness in the Nasdaq, even as the more traditional Dow is barely reacting to the rate move. The generally less mature, riskier stocks in the tech-heavy Nasdaq are more likely to have borrowed and to therefore be negatively impacted by this than the staid manufacturing and industrial stocks in the Dow. If rate hike expectations remain, or even increase, and the 10-Year yield keeps moving higher, you will see more relative underperformance in the Nasdaq.
In the long term, however, those more dynamic Nasdaq stocks still offer more upside. So, if you own them, either directly or through something like QQQ, don’t be panicked by the move down. The stocks that make up the Nasdaq are inherently more volatile than those in the Dow, but history shows that, over time, they outperform. Keep in mind that even a 2% yield on the 10-Year is low and is conducive to growth so, if anything, this move down in response to higher yields is an opportunity to buy some of the depressed Nasdaq stocks at a discount.
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