Equities are off to a lousy start to a short week. Sometimes it is hard to find the culprit for the market’s sour mood, but that is not the case this morning. Rising bond yields are getting the blame, and deservedly so. Yields on US Treasuries are about 5 basis points higher on 2 through 30 year maturities. More importantly, today’s rising rates come on the heels of several weeks of continually higher yields and lower bond prices, as the following graph shows:
US Treasury Yield Curve, Today (green, top) vs. 1 Month Ago (yellow, top), with Changes (bottom, in basis points)
While the rising yield curve might not appear all that dramatic at first glance, the lower graph gives real insight into the pace of the changes. Over the just past month we see rates rising about 40 basis points in the 2 through 30 year portion of the curve. The 2-year yield crossed the 1% level today. Although round numbers tend to be psychologically significant, I believe that explains only part of today’s nervousness in equity markets. Putting things in perspective, 2-year rates have nearly doubled in just over a month, and those sort of moves in fundamental building blocks of market pricing should certainly be expected to create dislocations elsewhere.
We have seen some remarkable dislocations of the yield curve over the past two years, as the following graph shows:
US Treasury Yield Curve, Today (green line, top), 1 Year Ago (green dashes, top), 2 Years Ago (yellow, top) with Changes – Today vs. 1 Year (green, bottom) and vs 2 Years (yellow, bottom)
Think about the above graph sequentially. Two years ago we had short-term rates in the 1.5% range, a flat yield curve, and stocks flirting with all-time highs (even if those levels were about two-thirds of today’s). A year later, short-term rates were near zero, the yield curve was positively sloping, though gently so, and the S&P 500 Index (SPX) was about 12.5% higher than it was a year earlier (though after a gut wrenching drop in March and a steady climb thereafter). Now we still see short-term rates anchored at zero, though the steeper yield curve indicates expectations of rate hikes in the near term and beyond. Even after the recent modest dip in stock prices, we see SPX about 23% higher over the past year. Interestingly, we see the rise in long-term rates brings them only to the levels of two years ago. Perhaps most importantly, the steep short end of the yield curve implies that even though we are anticipating higher short rates in the immediate future, they are not perceived to be sufficiently high to invert the curve. An inversion often presages a recession, and bond yields are not implying that one is on the market’s radar.
The takeaway is that investors have been dealing with major moves in the yield curve over the past year. The periods when the short end stayed anchored close to zero were quite favorable to equities. Even when we saw relatively higher short-term rates and a flattish curve, equities were able to push to what were then all-time highs. The risk of course is that those highs were about 30% below current levels.
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