Yields are trending back down

The soaring yield on 10-year Treasury debt looks as if it might have hit its high point, or be close to it.  That should be good news for equities, particularly for growth stocks.

Since the beginning of the year, the continued acceleration of inflation has led central banks to sound increasingly hawkish, driving the yield on the 10-year US Treasury up sharply.  This has triggered one of the worst year-to-date total return performance ever and created a panic in the equity markets.  The mechanism goes in reverse as well, boosting valuations when yields fall, as they have over the past three weeks.

The 10-year yield has dropped to 2.74% as off last Friday, from a multiyear high of 3.13% hit on 6th May.  It has soared to that level as investors sold fixed income securities, reasoning that the Federal Reserve would soon start reducing the vast holdings of bonds it has built up in its efforts to stimulate the economy over the years.

The yield’s recent fall isn’t just any old drop.  The latest move takes the number below a key level, the roughly 3% it hit in late 2018 before beginning a long decline.  In terms of technical analysis, the fact that yields have failed to pass that 2018 level means that they are less likely to do so now.

In effect, never in any tightening cycle by the Fed in the past 40 years have 10-year Treasury yields exceeded the high from the prior tightening cycle.  In other words, this could be it for the recent spike in Treasury yields.  We won’t know for sure for a few months, but it is possible that Treasury yields are headed down, if inflation calms down and the economy slows, which the Fed wants to happen.  Data released last Friday saw the core PCE price inflation, the Fed’s preferred inflation gauge, falling to 4.9% from a year earlier in April, the lowest in four months, pointing out that price increases could be slowing.

Importantly, yields at current levels are now high enough to attract buyers of 10-year debt.  At 2.74%, the yield is above the 2.5% average annual inflation that the market seems to expect over the next decade.  That means investors can now reap a real, inflation-adjusted return by owning the bond.  More buyers would keep the price higher and the yield lower.

Growth stocks are already starting to benefit from the perception that the yield might be finished climbing.  As the broader market has rebounded from a low point hit on 11th May, the Russell 2000 Growth exchange-traded fund (ticker: IWO) has gained 11.1%, doubling the gains on the S&P 500 and beating other major US indices.

Growth stocks are valued highly because investors expect them to pump out increasing profits for years to come.  When yields on long-dated debt rise, the current, discounted value of those future earnings falls, reducing what investors are willing to pay.  The hope is that price/earnings ratios for these stocks are done plummeting, which would make it possible for growth in profits to lift their prices.


Disclaimer: This article was written by Stephen Borg, Head of Private Clients at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd and is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

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