Bond Turbulence Pressures Stocks
U.S. stocks traded off and long-term U.S. government bond yields rose last week, with 10-Year yields briefly going above 4.20% (near the 15-year highs reached last year) before retreating back towards 4%. This volatility was triggered by a confluence of events including: the downgrade of the U.S. sovereign credit rating by Fitch, the Bank of Japan’s decision to adjust its yield curve control regime, and the announcement of the largest round of refunding auctions since last year. The recent surge in yields has been driven by real yields, or inflation-adjusted yields, suggesting that the market is repositioning for a potentially extended period of tighter Fed policy.
The increase in U.S. debt issuance as the government moves forward with infrastructure-spending plans feeds into the concern the fiscal stimulus, delivered by widening budget deficits, will add to the risk that the Fed will hold rates at elevated levels for longer to ensure inflation is restrained. Our current path is unsustainable. There is a record $17.1 trillion in household debt. Total credit card debt in the U.S. rose by $45 billion in the second quarter to a record $1.03 trillion, while the average interest rate on credit card debt just hit a record 25%. More than a third of Americans have more credit card debt than savings, and the average rate of a 30-year fixed rate mortgage just touched 7.4%. We are fighting inflation with debt. Market-implied inflation expectations over the next 5-10 years have risen to the highest levels in more than a year. Investors are shifting outlooks of a future with potentially higher inflation.
The soft-landing thesis that in large part has helped propel equities higher this year is beginning to be challenged. Initially, this month’s drawdown in stocks was in large part from rising yields pressuring technology companies and bond proxies. Then, earlier in the week, Moody’s downgraded the banking sector citing higher funding costs and exposure to commercial real estate. If the current disinflationary impulse of core inflation does not come with an eventual higher unemployment rate, which is still stuck at 3.5%, this lower inflation will lead to a boost in disposable income and continued wage inflation, and could restart a second inflationary wave. Key commodity prices continue to climb higher just as many central bankers were sounding optimistic about reigning in inflation. All eyes will be on tomorrow’s U.S. CPI release as economists are forecasting the July report will show headline annual inflation accelerated for the first time since it peaked in June 2022.
Demand for bank loans in the corporate sector fell to their lowest level since 2008. Tighter lending conditions point to a downturn in consumer credit ahead. The yield on short-term Treasuries now exceeds that of stocks and is at levels last seen during the Dot Com Bubble. While many parts of the U.S. economy remain robust, the cost of capital remaining high will continue to pressure corporate and household balance sheets. In an environment such as this, focusing on high quality, cash flowing companies is more important than ever.
Ryan Babeuf, CFA
Market Strategist
Ryan.Babeuf@EdgeWealth.com
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