By now, the average investor has heard that the U.S. 10-year government bond yield hit 3% early Tuesday for the first time in about four years.
So, what does that mean? Is it just a psychological barrier or a key threshold that could augur ill for the broader market?
There are a number of ways to think about the recent development. However, here’s what may be behind the rise in the benchmark yield, which is used as a barometer for borrowing costs for everything from car loans and home mortgages to corporate debt.
Economic growth
The Federal Reserve has been hiking interest rates since the end of 2015, a rate hike in March marked the sixth as the central bank attempts to normalize monetary policy after nearly a decade of accommodative rates in the wake of the 2008-09 financial crisis.
“Growth. First of all, it is telling us the economic growth picture is solid,” said Kristina Hooper, chief global market strategist at Invesco, in a research note.
That solid growth means that the Fed should be lifting interest rates to a more natural level. The Atlanta Fed President Raphael Bostic sees that level at 2.25% to 2.75%. In March, the Fed raised rates a quarter point to a range of 1.5%-1.75%. That suggests that the market could be do for three or four more rate increases before the end of the year. It is possible that the market is increasing its expectation for yields and driving prices yields, which move inversely to price, higher.
Inflation
Inflation is a bane to bondholders, eroding the value of their fixed payments. So, expectations for rising inflation, or prices, can force selling in Treasurys and drive yields higher.
Expectations for inflation, which had earlier been running below the Fed’s annual target of 2%, have shifted higher. San Francisco Fed President John Williams, who is poised to be the New York Fed boss, last week said the inflation should hit the central bank’s 2% goal this year and stay at or above that goal for “another couple of years.”
Rising crude-oil prices and the value of other commodities also are factoring in to these elevated inflation estimates. West Texas Intermediate crude oil for June delivery selling on the New York Mercantile Exchange has risen 5.7% so far in April, putting commodity on pace to register its best monthly gain since January, according to FactSet data. So far this, year, crude prices are up 12.2%, compared with a decline of 3.4% for the Dow Jones Industrial Average and a loss of 2% for the S&P 500 index in the first four months of the year.
Bonds versus stocks
Benchmark yields at 3% means that risk-free government paper can compete more decisively with assets perceived as risky like stocks. The average dividend yield for stocks trading on the S&P 500 index is 2%, while the dividend yield for the average Dow component is 2.4%. That friction can cause investors to re-evaluate their overall investment composition.
Moreover, higher 10-year yields imply that borrowing costs are climbing, making it more expensive for corporations to deliver earnings unless their businesses commensurately increase their performance along with the rise in rates.
This dynamic means that corporate earnings coming in mostly from the first quarter may not be good enough to justify investors paying relatively rich prices to own stocks.
Check out this report on equity valuations and yields from MarketWatch’s Anora M. Gaudiano, which explains that investors have been shaking off expensive stocks against an easy-money backdrop, but rates scaling higher rings warning bells.
A similar equity selloff in stocks occurred back in early February when yields mounted a charge higher, Hooper said: “We have already experienced this phenomenon in the past few months—recall the drop in stocks in early February when the 10-year yield rose materially—and so we will want to follow this situation closely. With regard to risk assets, I believe investors need to maintain exposure, but be well-diversified and discerning in this environment.”
Here comes the issuance
Additional fiscal boost to the U.S. economy coming from the tax cuts signed into law late last year by President Donald Trump and a two-year budget deal, are both underpinning expectations for a glut of issuance of Treasurys.
“Recently the US Congressional Budget Office released revised projections that show an expected increase in government deficits, which means the US government will most likely be issuing more government bonds. In addition, as part of its balance sheet normalization plan, the Fed is gradually increasing the sales of US Treasuries that it holds on its balance sheet. This all suggests there is a good possibility that, even if demand remains stable, supply will increase significantly—leading to falling Treasury bond prices and rising yields,” Hooper wrote.
Equity markets
The stock market hasn’t reacted favorably to rising rates on Tuesday because they mean everything is more expensive. That is to say, it may cost more for companies to generate profits.
The anticipated trend by bearish market participants is that yields will continue to climb.
“We are bearish US rates and think there are good macro reasons—including labor market strength, inflation normalization and a fiscal boost—for US Treasury yields to trend higher and so today’s move is consistent with the upward trend seen over the past several months and in line with our expectations,” wrote Iain Lindsay, co-head at Goldman Sachs Asset Management’s portfolio management and fixed-income unit.