Previous week's weekly market wrap
How big of a threat is the rally in rates?
Key Takeaways
- Yields have moved higher since the Fed initiated its first rate cut and rose further last week, interrupting the stock market's streak of gains.
- Driving the rise in yields has been a combination of stronger-than-expected economic and inflation data leading to a shift in Fed expectations. Concerns over U.S. debt and the upcoming election are also adding to the recent bond volatility.
- Yields could temporarily overshoot, but we don't anticipate them rising substantially or exceeding the 2023 highs. The labor market and inflation will likely continue to cool next year, allowing the Fed to gradually remove some of its restriction. Also, a likely split Congress will limit new fiscal initiatives.
- Despite several crosscurrents, yields appear to be rising for the right reasons. The economy remains resilient with recession probabilities continuing to drop. With the underlying fundamentals favorable, we recommend taking advantage of any market turbulence to lean into opportunities in equities and fixed income.
The stock market's six-week streak of gains was interrupted last week, as rising bond yields started to attract investors' attention. Just over a month has passed since the Fed kicked off a new easing cycle, cutting its policy rate by a larger-than-typical half a percentage point. Yet, during that time, both 2- and 10-year Treasury yields have climbed, challenging the prevailing narrative. Could the rally in rates pose a serious threat to the stock market's momentum?
To answer this, we examine the forces driving the recent rise in bond yields and explore the potential for further increases.
This chart shows that 2- and 10-year Treasury yields have risen since the Fed's September interest-rate cut. Past performance does not guarantee future results.
This chart shows that 2- and 10-year Treasury yields have risen since the Fed's September interest-rate cut. Past performance does not guarantee future results.
What's driving the rise in yields?
- Stronger-than-expected economic data – Over the past month economic surprises have improved, coinciding with the rise in rates. September's job gains were the strongest in six months and unemployment dropped, easing concerns about the state of the labor market. Moreover, the robust growth in retail sales has helped push the Atlanta Fed's real-time GDP estimate for the third quarter to 3.4%1. If realized, this would mark the second consecutive quarter of above-average growth, dispelling fears of a near-term recession that arose when the Sahm-rule was triggered by rising unemployment.
This chart shows the move higher in bond yields has coincided with improving economic surprises. Past performance does not guarantee future results.
This chart shows the move higher in bond yields has coincided with improving economic surprises. Past performance does not guarantee future results.
2. A shift in Fed expectations – Along with the strong economic data, markets have had to absorb a mild upside surprise in inflation, leading to expectations for a more gradual and shallower rate-cutting cycle than anticipated at the September Fed meeting. In response, bond markets have slightly repriced future rate paths. Another outsized rate cut is no longer expected, and the odds of a November quarter-point rate cut have fallen from 100% to 90%. By the end of 2025, markets now expect the Fed policy rate to be 3.5%, up from 2.9% a month ago1.
3. Potential for a sustained rise in productivity – One of the reasons the U.S. economy continues to defy expectations for a slowdown is the notable uptick in productivity, a trend not observed in other major economies. The adoption of new technologies and promising innovations such as artificial intelligence (AI) have the potential to increase the long-term growth rate of the U.S. A more productive economy could sustain higher growth without fueling inflation, justifying a higher steady state for interest rates relative to the last economic expansion.
4. Concerns over U.S. debt and the upcoming election – The U.S. presidential election on November 5 is fast-approaching and is raising fiscal concerns. Based on campaign proposals, the elevated debt will likely increase further under both candidates. According to the Committee for a Responsible Federal Budget, a nonpartisan, nonprofit organization, Harris’s plan would increase the debt by $3.50 trillion through 2035, while President Trump’s plan would increase the debt by $7.50 trillion. Stimulative fiscal policy either via tax cuts or additional spending may force the Fed to leave its policy rate higher than it would have done otherwise. And the increased supply of bonds to finance the higher debt could pressure long-term Treasury yields.
The election appears incredibly close, but as the odds of Trump winning edge up in the betting markets, investors are deliberating the potential impact of additional trade tariffs. Economic theory suggests that tariffs would be inflationary. However, in practice there are many moving pieces that affect how the additional cost might flow through to the consumer. Part of the increased cost could be eaten by retailers, and the potential weakening of foreign currencies relative to the U.S. dollar could make them cheaper.
This chart shows that the S&P 500 has gained over the past year despite several shifts in expectations for the U.S. presidential outcome. Past performance does not guarantee future results. An index is unmanaged, not meant to depict an actual investment and cannot be invested into directly.
This chart shows that the S&P 500 has gained over the past year despite several shifts in expectations for the U.S. presidential outcome. Past performance does not guarantee future results. An index is unmanaged, not meant to depict an actual investment and cannot be invested into directly.
How high can yields go?
Recent rate volatility in the U.S. Treasury market reached its highest since last December, with the 10-year yield climbing from around 3.60% to 4.20%1. As the Federal Reserve lowers rates over time to ease policy and normalize conditions, we estimate the fair value of the 10-year yield to be between 3.5% and 4.0%. In the near term, yields could temporarily overshoot toward 4.5%, but we don't anticipate them rising substantially or exceeding the 2023 highs for several key reasons:
- Soft-landing as the base case: Our base-case scenario remains a "soft landing," where the economy shifts from rapid growth to slower expansion without entering a recession. In this scenario, the Fed can normalize policy at a measured pace. Recent data have fueled hopes for a "no landing" scenario, in which case growth does not slow and the Fed is forced to keep rates high for longer. Despite the strong September jobs report, broader labor-market trends suggest that employment conditions are cooling. As wage growth moderates and consumer spending softens, overall growth will likely slow.
- Inflation: Despite some bumpiness along the way, inflation will likely reach the Fed's 2% target in 2025. Housing inflation, the largest component of the CPI basket, remains elevated but will likely normalize, as suggested by real-time rent data for newly signed leases. A gentle slowdown in economic growth and employment will also help ease price pressures in the services sector.
- Fed policy: While there is debate about the pace, the Fed will likely continue to cut rates through 2025 to remove some of its restriction. Even after the initial 0.5% cut, the real Fed policy rate (after adjusting for inflation) remains near the highest of the past 20 years1. Whenever the Fed has cut rates in the past, it has pulled yields lower across the curve. That was also the case in the mid-1990s soft-landing example. Initially, the 10-year yield rose 0.6% following the Fed's July 1995 rate cut, but the downtrend resumed, and by October yields were making new lows for the year1.
- Split Congress limiting fiscal policy: A divided government will limit new fiscal initiatives. Regardless of who occupies the White House, control of Congress will matter more for the extent of any new spending or fiscal programs. Current polling suggests Democrats could retain the Senate while Republicans may take a majority in the House. This would create gridlock, limiting major fiscal policy shifts, and would therefore be less disruptive to the Treasury market.
- Strong demand for U.S. government bonds: Demand for U.S. Treasuries will likely remain robust as the U.S. economy continues to perform relatively well, and its financial markets remain the largest and most liquid globally. Although concerns over long-term debt sustainability persist, U.S. Treasuries are still viewed as a safe haven, especially in times of uncertainty. This was evident in 2011 when U.S. yields dropped following the downgrade of the country’s credit rating.
This chart shows that the 10-year U.S. Treasury yield rose initially following the 1995 easing cycle before resuming lower. Past performance does not guarantee future results.
This chart shows that the 10-year U.S. Treasury yield rose initially following the 1995 easing cycle before resuming lower. Past performance does not guarantee future results.
The bottom line
Despite several crosscurrents, yields appear to be rising for the right reasons. The economy remains resilient with recession probabilities continuing to drop. Financial market signals are also consistent with a broadly positive backdrop. Since the Fed's initial rate cut, sector leadership has been balanced, with both growth and cyclical sectors outperforming defensives, while credit spreads have tightened to historically low levels.
Given the strong equity gains year-to-date and election uncertainties, a further rise in yields could lead to some market volatility. However, we believe there is limited potential for a sustained rally. With the underlying fundamentals remaining favorable, we recommend taking advantage of any market turbulence to lean into opportunities.
On the fixed-income side, higher yields offer another chance to extend the duration of portfolios. Repositioning into intermediate- and long-term bonds where appropriate can lock the high yields for longer, while cash rates follow the Fed policy rate lower over the next several years.
This chart shows the option adjusted spread for the Bloomberg U.S. Corporate High Yield Bond Index. Spreads remain tight from a historical standpoint. Past performance does not guarantee future results. An index is unmanaged, not meant to depict an actual investment and cannot be invested into directly.
This chart shows the option adjusted spread for the Bloomberg U.S. Corporate High Yield Bond Index. Spreads remain tight from a historical standpoint. Past performance does not guarantee future results. An index is unmanaged, not meant to depict an actual investment and cannot be invested into directly.
Angelo Kourkafas, CFA
Investment Strategist
Source: 1.Bloomberg
Weekly market stats
INDEX | CLOSE | WEEK | YTD |
---|---|---|---|
Dow Jones Industrial Average | 42,114 | -2.7% | 11.7% |
S&P 500 Index | 5,808 | -1.0% | 21.8% |
NASDAQ | 18,519 | 0.2% | 23.4% |
MSCI EAFE* | 2,361.47 | -2.0% | 5.6% |
10-yr Treasury Yield | 4.24% | 0.2% | 0.4% |
Oil ($/bbl) | $71.65 | 4.3% | 0.0% |
Bonds | $98.59 | -0.9% | 2.2% |
Source: FactSet, 10/25/2024. Bonds represented by the iShares Core U.S. Aggregate Bond ETF. Past performance does not guarantee future results. *Morningstar Direct 10/27/2024.
The week ahead
Important economic releases this week include PCE inflation data and the nonfarm payrolls report for October.
Angelo Kourkafas
Angelo Kourkafas is responsible for analyzing market conditions, assessing economic trends and developing portfolio strategies and recommendations that help investors work toward their long-term financial goals.
He is a contributor to Edward Jones Market Insights and has been featured in The Wall Street Journal, CNBC, FORTUNE magazine, Marketwatch, U.S. News & World Report, The Observer and the Financial Post.
Angelo graduated magna cum laude with a bachelor’s degree in business administration from Athens University of Economics and Business in Greece and received an MBA with concentrations in finance and investments from Minnesota State University.
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The Weekly Market Update is published every Friday, after market close.
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