Bond Market Setting the Tone

by: Richard A. Anderson

Last Wednesday, October 10th, U.S. stocks suffered their worst losses in eight months. The Dow Jones Industrial Average declined 3.2% and the S&P 500 declined 3.3%, both notching their worst losses since February 8th. The S&P 500 also posted its first six-day losing streak since November 2016, although a bounce back on Friday stopped that slide.

While stocks stole the headlines, the bond market was the catalyst for the stock market selloff as yields on U.S. Treasury bonds rose to seven-year highs. Following its September meeting, the Federal Open Market Committee (FOMC) announced it was hiking short-term interest rates to a target range of 2%-2.25%. The Fed also reaffirmed its plans to raise interest rates one more time this year, three times in 2019, and one more time in 2020. These decisions, which were expected, are a sign of increased confidence in the U.S. economy as unemployment is low, economic growth is steady, and corporate profits are strong. The Fed’s goal is to raise interest rates steadily to prevent the economy from overheating but avoid raising rates so aggressively that it could help spur a recession.

Historically, because these interest rate hikes were anticipated by market participants, the markets didn’t skip a beat. In fact, markets responded positively to the news. So, what changed?

On Wednesday, October 3rd, Federal Reserve Chairman Jerome Powell stated in an interview with Judy Woodruff of PBS that the central bank is a long way from interest rates that are neither restrictive nor accommodative. Powell’s statement stoked concerns that the Fed could raise rates at a faster pace, which sent stock and bond prices plummeting in tandem. Following Powell’s interview, global stocks went on a 6-day losing streak. The S&P 500 declined by 6.7% and international stocks, as measured by the MSCI All Country World Index ex USA, declined 6.0%.

In addition, interest rates have jumped. The U.S. 10-Year Treasury yield moved from 3.05% to a high of 3.22% before settling at 3.15% on Friday. The U.S. 2-Year Treasury yield moved from 2.82% to a high of 2.88%, ending at 2.85% on Friday. Bond yields and bond prices move in opposite directions. When yields increase, prices decline. The opposite is also true. This is often referred to as an inverse relationship.

Yields on U.S. Treasury bonds are important for many reasons. Yields on Treasury bonds are the benchmark to help determine interest rates for borrowers from home buyers to large corporations. While higher interest rates are a sign of a stronger economy, it also makes borrowing more expensive for consumers and businesses.

Higher interest rates can also make stocks look less attractive. More conservative investors won’t feel the need to invest in riskier stocks when they can earn 3% by investing in risk-free U.S. Treasury bonds. This could potentially result in investors pairing back their gains from this 9-year bull market and putting those proceeds in Treasury bonds.

For these reasons, higher interest rates can be viewed as a double-edged sword.

What’s been different about this recent sell-off is that stocks and bonds have both declined together. Historically, bonds tend to provide a counterbalance when stocks decline. When investors seek a “flight to quality” they buy U.S. Treasury bonds, which drives bond prices up and interest rates down. While it’s uncommon for stock and bond prices to decline precipitously at the same time, this isn’t the first time and it won’t be the last.

Actually, we don’t even need to go that far back to see when it happened last. Earlier this year, in late January through early February, concerns over inflation caused stocks and bonds to drop. Over the 9 trading days from January 26th to February 8th, the S&P 500 declined by 10.2% and the Bloomberg Barclays U.S. Aggregate Bond Index fell 1.21%.

Following the short-term pullback earlier this year, both stocks and bonds continued to reward investors who remained disciplined or bought when prices were discounted.

At HIGHLAND, our view is the recent sell-off is an overreaction to Fed Chairman Powell’s comments about future Fed actions. The fears that the Fed will choke economic growth by hiking interest rates too quickly are overblown. The market traders will refocus on the fundamentals of the economy, and after this quarter’s earnings from U.S. companies, we believe this will play out in a similar manner as the market pull back in January of this year and in November 2016. As in the past, markets bounced back and rewarded investors who had the patience to withstand the price drops.

If you have any questions about the recent market volatility or the changes we are making to combat the effects of future interest rate increases, please do not hesitate to contact a member of the HIGHLAND team.