Bear Steepening Rattles Markets
Longer-dated yields in the roughly $25 trillion U.S. Treasury market remained on a merciless rise on Tuesday that roiled investors across global financial markets. The 30-year Treasury ended above 4.9%, while the benchmark 10-year climbed to 4.8%, both marking levels not seen since 2007. The surprising resiliency of the U.S. economy, as demonstrated by Tuesday’s jobs openings report, played a big part in the run-up in yields. Job openings jumped to 9.6 million in August, challenging expectations for the labor market to wither after more than five full percentage points of Fed rate hikes since March of last year. Continued economic strength likely means that Fed policy will remain tight. Rising long-term Treasury yields are generally a signal of a positive economic outlook. However, this time around, the move in yields has more to do with sticky core inflation, a greater-than-expected U.S. budget deficit, and the need for the Treasury to issue more supply. The spread between the 2- and 10- year yields narrowed to as little as -35 basis points on Tuesday, steepening from the triple-digit negative levels seen earlier in the year.
With a tight labor market still driving consumer spending, Fed officials have indicated they will keep interest rates higher for the foreseeable future and could add another rate hike before year-end. U.S. mortgage rates topped 7.5% last week for the first time since November 2000, and applications for home purchases dropped to a multi-decade low, illustrating a battered housing market. Higher mortgage rates and elevated home prices, due in large part to limited supply, is contributing to one of the most unaffordable housing markets on record.
Equity markets are hoping the labor market will loosen up enough to give the Fed breathing room to dial down its current hawkish stance. The Fed’s ultimate goal is to get inflation back to their 2% target, but with core PCE inflation currently at 3.9%, they are not there yet. Crude oil prices are up over 20% since midyear. Most of that rise can be attributed to a negative supply shock, however there are concerns that the supply cuts are not finished. Rising energy costs contributes to the battle we’re witnessing in U.S. equity markets along with a stronger dollar, rising yields, and a hawkish Fed, juxtaposed with a resilient economy, fiscal expansion, and improving corporate profits. Fed funds futures markets are currently pricing in one more rate hike by year-end, largely because of the fiscal stimulus and recent surge in oil. Core PCE is still influenced by crude oil prices, so rising oil prices and fiscal expansion increase the chance of more tightening.
The concern arises in early 2024 when fiscal stimulus shrinks, and the impact of monetary policy kicks in as a result of “long and variable lags.” Without the support of fiscal policy, rates will likely be too restrictive, and the economy could weaken quickly. With a U.S. equity risk premium at its lowest since the global financial crisis, stocks would be vulnerable in this environment. With U.S. stocks trading roughly at a forward earnings yield of 5.3% and a dividend yield of 1.6% respectively, compared with a money market rate of 5.5% and long-bond yields at 4.9% respectively- the gap between cash and dividend yields is the widest since 2000, highlighting a distortion and that cash has become a viable alternative.
Markets will continue to reprice on expectations of whether we are beginning a new rate regime to reflect America’s exploding budget deficits and wave of Treasury issuance. All eyes will be on tomorrow’s monthly employment report as participants will be looking for labor market cooling. Given these headwinds, we continue to favor high-quality fixed income, select well-capitalized large cap equities, and maintain ample cash and short-dated Treasury ETF weightings.
Ryan Babeuf, CFA
Market Strategist
Ryan.Babeuf@EdgeWealth.com
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