Over the past week, investors have been fixated on the sudden volatility present in the equity markets. The Dow plunged almost 5% on Monday, the sharpest decline in almost seven years. While we believe this is likely to be the beginning of a larger-degree pullback in the short to intermediate-term, the overall upward trend remains intact — for now.
The underlying cause of this sell-off is not a simple matter of profit taking, but mainly, the sharp rise in Treasury yields. While the 5-year yield had already snapped its roughly 35-year downward trend since the early 1980s, the 10 and 30-year treasuries had yet to follow suit.
That is simply no longer the case for the 10-year note…
In the chart below, there is a critical breakout underway. This is one of the major economic shifts in our lifetime and the end of an era assuming the 30-year yield also mirrors that of the shorter-term notes.
So what do rising Treasury rates actually imply?
These bonds, sold by the U.S. government, are a key marker of investor confidence. If rates are rising, bond prices fall, a sign that investors believe they can capture higher returns in other investment vehicles. They believe “playing it safe” is no longer an appealing and/or appropriate investment strategy.
It’s all about supply and demand. Right now, there isn’t a whole lot of the latter, so the government must incentivize (pay more in yield) investors in an effort to lift demand at future auctions.
So if there’s so much confidence in the system, why should we be cautious?
As yields climb, banks and lenders will take that signal as a green light to hike mortgage rates, thus making housing less affordable. The 10-year Treasury yield is one of those key benchmarks used when makings these rate adjustments. Hence, optimism comes at a cost.
Higher rates are costly for businesses too. With a low unemployment rate, there are so many jobs available that companies will be forced to pay more in an effort to retain current employees while attracting new ones. And so, prices will eventually need to be raised (inflation) on goods and services sold to support growing payrolls.
The Federal Reserve can act to counter the effects of inflation by boosting interest rates. Hence, the cost of borrowing capital increases, resulting in companies having to pay more for loans in an effort to fuel growth.
Common sense tells us that when companies shell out more money to service debt, profits are going to take a hit. Eventually, investors will sour and punish the market, fueling a fear-induced stock market selloff, likely leading to the next economic recession.
It’s just a matter of figuring out where we are in the grand economic cycle. From our perspective, the party is much closer to the end than people think.
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