How Do Bond Yields Affect Cyclical Sectors In The Stock Market?

Key takeaways

Inflation

The disinflation process has begun.

Interest rates

Lower bond yields will likely follow.

Stocks

Rate-sensitive, early-cycle stocks may benefit.

Are rising or falling bond yields good or bad for cyclical sectors? The answer is yes! While that may not seem like a serious response, it truly depends on the economy-sensitive sector in question at a given stage of the market cycle. As my regular readers know, I think we’re on the leading edge of a stock market recovery — it seems inflation has stabilized, the Federal Reserve may soon wind down interest rate hikes, but I believe the recovery will require the participation of the consumer discretionary sector. So let’s start there.

As an equity strategist, I care about the direction of interest rates — especially the 10-year US Treasury bond yield — because they’re the discount rate for stocks. As we saw through much of 2022, rapid increases in bond yields can dramatically lower the present value of businesses’ expected cash flows. As we’ve seen since October of the same year, however, that process can also work in reverse (i.e., lower bond yields and higher share prices).

Are bond yields heading higher or lower?

One way for investors to get their arms around the prevailing direction of interest rates is by assessing the outlook for the general level of prices in the economy.

Anyone on a fixed income over the past few years understands how accelerating prices for basic necessities — food, rent, medical care, energy, cars, etc. — sap their ability to spend on other more discretionary items. Contrastingly, decelerating prices boost consumers’ ability to spend on discretionary things.

The same principle applies to the bond market. Faster inflation takes a real bite out of fixed coupon payments, thereby reducing the value or attractiveness of outstanding debt issues (Figure 1). Meanwhile, disinflation or outright deflation have the opposite effect (i.e., higher bond prices and lower bond yields).

Figure 1. Peak inflation points to lower bond yields for now

What’s the outlook for US inflation?

In a February 7, 2023, speech, Federal Reserve (Fed) Chairman Jerome Powell said, “The disinflationary process, the process of getting inflation down, has begun…,”¹ an official statement that ratifies my favorable views on the general level of prices and bond yields.

In fact, the symmetrical roundtrip of the Institute for Supply Management (ISM) Manufacturing Prices Index — from its trough of 35.3 in April 2020 to its peak of 92.1 in June 2021 and back to contraction territory since September 2022² — suggests a strong whiff of outright deflation in the goods sector. 

Powell added that in the non-housing sector, “Services [are] not really showing any disinflation yet.”¹ From my lens, however, the annualized 3-month percent change in the Consumer Price Index (CPI) for services excluding shelter has plummeted to a low single-digit pace. Perhaps the “immaculate” disinflation scenario I first wrote about in May 2022 is playing out.

Powell also mentioned that taming inflation “will be a process that takes a significant period of time.” However, I suspect policymakers and investors will be caught off guard by how quickly the disinflationary impulse asserts itself. On a year-over-year basis, headline CPI decelerated for the seventh consecutive month in January 2022, an observation that seems to have escaped recent market commentary.

How do disinflation and lower bond yields affect consumer cyclical stocks?

In a finance-based economy dominated by consumers, the relationship between interest rates and spending is intuitive. When the cost of money or debt rises, consumers think twice about applying for mortgages to buy a house, loans to buy cars, and credit cards to finance spending on other goods and services.

When interest rates fall, however, debt-fueled consumption becomes more manageable, thereby improving households’ financial outlook.

If I’m right about an inflection point in consumer prices, declining bond yields, and a calmer Fed reaction function, those dynamics should support rate-sensitive, early-cycle consumer discretionary stocks (Figure 2).

Figure 2. Declining bond yields have supported rate-sensitive, early-cycle stocks

After a period of normalization and recovery, I’d expect inflation and bond yields to eventually drift higher once again on the back of an expanding economy.

If what’s past is prologue, that stage of the market cycle and change in the direction of interest rates will likely have a different effect on other later-cycle sectors such as financials, industrials, and materials. But that’s a story for another day.

Footnotes

• 1Source: Transcript of Jerome Powell speech, Feb. 7, 2023, The Economic Club of Washington, DC
• 2Institute of Supply Chain Management 

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Originally Posted March 3, 2023

How do bond yields affect cyclical sectors in the stock market? by Invesco US

Important information

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This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.

All investing involves risk, including the risk of loss.

Diversification does not guarantee a profit or eliminate the risk of loss.

Past performance does not guarantee future results.

Investments cannot be made directly in an index.

In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.

Fixed income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.

A bond’s yield is the return to an investor from the bond’s interest, or coupon, payments.

A cyclical sector is an equity sector whose price is affected by ups and downs in the overall economy.

The discount rate refers to the rate of interest that is applied to future cash flows of an investment to calculate its present value. It is the rate of return that companies or investors expect on their investment.

Inflation is the rate at which the general price level for goods and services is increasing.

Disinflation, a slowing in the rate of price inflation, describes instances when the inflation rate has reduced marginally over the short term.

Deflation is a decrease in the general price level of goods and services that occurs when the inflation rate falls below 0%.

The Consumer Price Index (CPI) measures change in consumer prices as determined by the US Bureau of Labor Statistics. Core CPI excludes food and energy prices while headline CPI includes them.

Aninflection point isan event that results in a significant positive or negative change in the progress of a company, industry, sector, economy or geopolitical situation.

The ISM Manufacturing Index, which is based on Institute of Supply Management surveys of manufacturing firms in the US, monitors employment, production, inventories, new orders and supplier deliveries.

The S&P 500® Index is a market-capitalization-weighted index of the 500 largest domestic US stocks.

The opinions referenced above are those of the author as of March 3, 2023. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.