Equity investors have been spooked by rising bond yields, and now bond investors are spooked by falling stock market selling. Markets are worried about a slowing economy and are now pricing in expectations that the Federal Reserve may not be able to raise interest rates as much as expected. “I think first in the market you see bond yields falling as equities fall, which means the market is pricing in more of a slowdown,” said Jim Caron, head of macro fixed income strategies. worldwide at Morgan Stanley Investment. Management. “Markets are pricing in a downgrade in growth forecasts and a downgrade in earnings.” Falling stock prices are just one concern, but bond strategists say the stock market’s continued decline is a direct reflection of the economy’s slowing growth. The S&P 500 fell 20% from its peak and fell 0.8% on Tuesday. Caron said the tone of the bond market has changed over the past few weeks and investors now expect fewer interest rate hikes from the Fed. They are also adding longer dated securities to their portfolios. “We’re seeing people add duration. We’re seeing money come in and buy long-duration bonds because they act as a hedge against risky assets,” Caron said. “I think this is the first time I’ve seen this. For the first time this year we’re seeing people add duration to their portfolio as a hedge.” The benchmark 10-year Treasury yield has recently been on a downward trajectory. It was above 3% on May 18 but has fallen sharply since. The 10-year is essential because it influences the rates of mortgages and other loans. On Tuesday, the 10-year fell to 2.79%, a support zone, and fell as low as 2.71%. It was at 2.75% in afternoon trading. “I think that tells us that the market is increasingly concerned about the state of the recovery and how much tightening the Fed will be able to achieve,” said Ben Jeffery, rates strategist at BMO. The 10-year has been pegged to the stock market for much of this year. As the yield grew rapidly, the names of technology and growth faded. Yields rose alongside expectations of higher interest rates from the Federal Reserve. Cheap money helps fuel valuations, and stocks with long-term growth prospects are the most vulnerable when interest rates start to rise. Thus, stock market strategists see a declining return somewhat as the release of a pressure valve. But this development may not be too uplifting for the stock market, as a slowdown in economic growth would also hurt equities. “It now seems that for a week or ten days growth has dominated the discussion, whereas for a while it was inflation, inflation, inflation,” said Michael Schumacher, director of the rates strategy at Wells Fargo. “You could say that equities are synonymous with growth.” Bond yields, which move in the opposite direction to bond prices, fell on fears that weaker economic data would warn of a slowing economy ahead. Meanwhile, Fed Funds futures are pricing in reduced expectations for Federal Reserve interest rate hikes on fears that the Fed’s own increases could cause more problems for the economy as she slows down. The latest batch of weak data pushed yields lower on Tuesday. Sales of new homes, for example, fell more than 16% in April. Markets are awaiting durable goods data on Wednesday morning and the minutes of the latest Fed meeting released in the afternoon. This was the meeting where the central bank raised interest rates by 50 basis points. One basis point equals 0.01 of a percent. Schumacher said federal funds futures had priced 1.94 percentage points in additional Fed rate hikes this year, but that fell to 1.83 points after Tuesday’s morning data. The futures market was still positioned for 50 basis point gains in June and July, but expectations fell another 50 basis points in September. “Today feels like a pretty big break,” Schumacher said. “It’s a holiday week. Liquidity is light…Volatility has been very high. People are nervous and taking a lot of risk ahead of the long weekend.” The economy contracted at a 1.4% pace in the first quarter, and forecasts from the Atlanta Fed’s GDPNow tracker now call for positive growth of 2.4% in the second quarter. Even with yields falling, strategists don’t see much more downside. “It’s going to be tough to see 10-year Treasury yields go much below 2.60% unless you think the Fed isn’t going to the neutral key rate,” he said. He added that this level would be 2.5%. “If that happens, the market believes the Fed won’t hit 2.5% or there will be a recession and the curve will invert,” Caron said. “As long as the Fed goes up, it will be hard for those yields to go down.”
Bond market counts on Fed to do less on interest rate hike
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