Rising Treasury Yields and Market Volatility

Implications for The Federal Reserve

Aug 23, 2023

Treasury Yields, Monetary Policy, US Dollar Strength and Market Reactions.

U.S. Treasury yields continue to surge as yields reach a 16-year high. The Fed must determine its monetary policy with inflation above target and interest rates rising to disruptive levels. Amidst these developments, the U.S. dollar maintains its strength, dominating the foreign-exchange market despite rising fiscal debt and political uncertainties. The combination of rising bond yields and high stock valuations is causing volatility in the stock market, leading to shifts in asset allocation.

Before Article Market Predictions:

Federal Reserve Course Of Action

The U.S. economy's robust performance has sparked concerns among investors that the Federal Reserve might tighten its monetary policy further. Tightening of monetary policy often involves raising interest rates to curb inflation and slow down economic growth. Interest-rate markets are predicting no further rate hikes from the Federal Reserve and even rate cuts starting in May 2024. This assumption is based on the expectation that inflation will decrease back to 2%.

However, the U.S. Federal Reserve is not expected to cut interest rates anytime soon, according to Goldman Sachs. The investment bank predicts that rate cuts will not occur until 2024. If Powell signals that rates need to go significantly higher to achieve inflation targets, it could become a cause for concern among investors. The anticipation is that Jerome Powell, the Chair of the Federal Reserve, may use the upcoming Jackson Hole meeting as an opportunity to signal the central bank's intentions to the market.

Rising Treasury Yields

Treasury yields have been on an upward trajectory, reaching a 16-year high. In particular, the benchmark 10-year Treasury yield has shown a significant rise since its low point in April, currently standing at 4.35%. This marks a level not observed since late 2007. Additionally, the yield on 10-year TIPS has surpassed 2% for the first time since 2009. This surge can be attributed to investors' expectations that interest rates will remain high even after the Federal Reserve concludes its rate hikes. Surprisingly, this increase in Treasury yields has taken place amidst a backdrop of decreasing CPI, as indicated by moving averages over recent months.

U.S. Treasury bonds are considered one of the safest investments due to the low risk of default. The yield on these bonds is often used as a benchmark for other interest rates in the economy and has significant implications for the bond market overall. Higher yields make new bonds more attractive to investors, leading to a decrease in demand for existing bonds and consequently, a drop in their prices. This dynamic has led to investors offloading bonds, further exacerbating the situation.

Several factors are contributing to this rise in bond yields. Larger-than-normal U.S. Treasury issuance this month, the Bank of Japan allowing yields to rise and credit-ratings firm Fitch downgrading the U.S. credit rating have all contributed to rising yields. As well, there are fundamental factors contributing to this rise as well. Stronger-than-expected retail sales, housing starts, and industrial production data have supported the belief that the U.S. economy is experiencing a soft landing. Th strength in the U.S. economy could prompt the Fed to raise or maintain interest rates at restrictive levels for a longer period of time, thereby pushing up bond yields.

Higher treasury yields can also have several implications for financial markets as well. For borrowers, higher yields mean higher borrowing costs, which can discourage investment and spending. For investors, higher yields can make bonds more attractive relative to other investments, potentially leading to a shift in asset allocation.

This surge in bond yields is part of a larger narrative driven by diminishing recession likelihood and increasing federal budget deficits which has lead to a rise in the supply of Treasury debt. The bond market's recent movements have led to expectations that the era of ultra-low interest rates following the financial crisis is coming to an end. Investors now anticipate that the Fed will maintain elevated interest rates for a longer period than previously anticipated. This is a cause for concern among investors as Treasury bond yields have already reached their highest levels since the 2008-09 financial crisis.

Dollar Strength

Despite concerns about rising U.S. fiscal debt and political dysfunction, the dollar continues to dominate the foreign-exchange market. The dollar's dominance can be attributed to several factors, including the size and strength of the U.S. economy, its growth prospects, and its global status.

The strength of the dollar is closely tied to interest rates and treasury yields. As yields rise, the dollar often strengthens as higher interest rates attract investors seeking a higher return on their investments. This can have significant implications for global trade as a stronger dollar makes U.S. goods more expensive for foreign buyers, potentially impacting U.S. exports. It also makes foreign goods cheaper for U.S. consumers, which can increase imports and potentially exacerbate trade deficits. Furthermore, a strong dollar can be detrimental for emerging markets that have borrowed heavily in dollars, as it increases their debt servicing costs.

Stock Market Implications/Reactions

The combination of rising bond yields and high stock valuations has made stocks less appealing compared to bonds. The equity risk premium, which is the excess return that investing in the stock market provides over a risk-free rate (such as Treasury bonds), has become slim due to rising bond yields. This situation poses a challenge for stocks and could potentially lead to a shift in investor preference from equities to bonds. However, some investors believe it is premature to assume that the rally in stocks is over, stating that a significant shift in the market would only occur with a definitive change in the economic environment, such as rising unemployment or falling corporate earnings.

Concerns about global economic growth have also contributed to market volatility. Several major economies, including Germany and China, have experienced a slowdown in growth. This slowdown has raised concerns about the health of the global economy and the potential impact on corporate earnings. Corporate earnings are a key driver of stock market performance, as they reflect the profitability of companies. When corporate earnings decline, it can lead to a decrease in stock prices, affecting the wealth of investors and potentially leading to a decrease in consumer spending.

The S&P 500 index, is experiencing its largest monthly loss of 2023 due to rising Treasury yields and concerns about the Federal Reserve's interest rate policies. The Nasdaq Composite and Dow Jones Industrial Average have also suffered losses.

In response to these developments, some market strategists have adjusted their investment strategies. Wells Fargo Investment Institute has reduced exposure to tech stocks and invested in Treasury bills instead. Despite this, tech shares have helped support stock indexes as investors are willing to look past the potential impact of higher yields and showed confidence in popular stocks such as Nvidia.

Wrap Up

The rising treasury yields, coupled with the Federal Reserve's potential interest rate policies, has created a complex financial landscape for investors.
The strength of the dollar, despite concerns about U.S. fiscal debt and political dysfunction, continues to dominate the foreign-exchange market.
The stock market has shown signs of volatility, with major indexes experiencing losses due to concerns about global economic growth and rising yields potential impact on corporate earnings.

After Article Market Predictions:

For more analysis on these topics, check out these articles:

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