Time to read: 3 min
Last week brought bad news on trade and Brexit, yet stocks globally shrugged off the news and rose higher. In the US, the S&P 500 Index hit new highs (albeit on low breadth), while the yield on the 10-year Treasury bond surpassed the key 3% level.1 Because the 10-year US Treasury yield tends to be a far more accurate fear gauge than any equity indicators (such as the VIX), I can’t help be fixated on a few questions: Why did the 10-year yield rise? And where will it go from here?
Forces that affect the 10-year yield
To understand why the yield rose, it’s important to understand what forces impact the 10-year yield. It is widely viewed that the three determinants of the 10-year yield are growth expectations, inflation expectations and the term premium.
Simply put, term premium is defined as the excess yield that investors require to commit to holding a long-term bond rather than holding a series of shorter-term bonds. In a research note in 2007, the Federal Reserve Bank of San Francisco explained that “a key component of the term premium is investor expectations about the future course of short-term interest rates over the lifetime of the long-term bond.”2 And that, of course, is dependent on expectations about the economy in the future. That’s why a rise in the 10-year yield versus shorter-term Treasuries is usually viewed as positive, as it suggests investors are more optimistic about the future of the economy.
But “term premium” is a catch all category dictated by supply and demand. And supply and demand is impacted by central bank selling and new debt issuance, as well as the fear trade and the yield trade, as I have articulated in previous blogs.
The ‘fear trade’
Let me focus in on the fear trade. Typically, as investors have become worried about macroeconomic and market conditions, their “safe haven” asset of choice has increasingly become US Treasuries. When demand for Treasuries increases, yields go down, all else being equal. And last week saw many developments that I believe should have caused worry among investors:
- US-China trade tensions increased, with China rewarding other trading partners with lower tariffs as it worked to alienate the US in their dispute. In my view, this was a smart decision that showed China is playing chess while the US is playing checkers when it comes to trade.
- At a critical meeting of the 27 European Union (EU) member countries, UK Prime Minister Theresa May’s Chequers plan (which outlined terms for the UK’s post-Brexit relationship with the EU) was rejected. She is now coming under increasing pressure from within the UK, and a no-deal Brexit seems increasingly likely.
- Italy’s government must decide on a budget by Sept. 27, but as I have been saying, it must reconcile the competing interests of its coalition government and the EU’s mandate for fiscal discipline.
And so it seems surprising that in a week of significant disruption and macro worries, investors bought more risk assets and had less demand for perceived safe haven assets such as Treasuries.
Concerns about inflation are rising
When I examine the recent rise in the 10-year yield, especially given other recent developments such as the escalation in trade wars, I believe it can be attributed to an increase in inflation expectations. And so, while investors are celebrating stock market returns and a steepening of the yield curve (which arguably suggests we are further away from a recession), I am concerned because inflation caused by tariffs would not be a positive development for any economy, let alone the US economy, in my view.
From my perspective, market activity in the last week does seem to suggest that investors are at least beginning to understand that trade wars may be a likely reality — and that the US may not come out on top. I believe this understanding is reflected in the rise in the inflation expectations component of the 10-year US Treasury yield, the recent weakening of the US dollar, and the performance of Chinese stocks last week. The Shanghai Stock Exchange Composite Index rose more than 4% last week after being beaten down for much of 2018.3
There is so much on the docket in the coming days:
- A possible US government shutdown looms large as this week the House must pass a major bill that includes both defense and domestic spending for the coming months. President Donald Trump has vowed to veto the bill as it falls far short of his $5 billion request for building a wall along the US-Mexico border. I believe the US will be able to narrowly avoid a shutdown, but this is likely to be a nail-biter.
- The deadline of Sept. 30 is approaching for the US and Canada to agree on revisions to the North American Free Trade Agreement. I think it is unlikely that the deadline will be met, although I wouldn’t be surprised to see some kind of extension of that deadline.
- Trade tensions are likely to continue to simmer or even escalate in the wake of China’s cancellation of trade talks scheduled for this week.
Most importantly, the US Federal Reserve (Fed) meets this coming week. I believe it is a fait accompli that the fed funds rate will rise to the 200-225 basis point range. What I will be looking for are signs of concern about tariffs and other reasons why the Fed may not raise rates again in 2018 — or signs that the Fed is becoming increasingly worried about inflation, which of course may force it to raise rates again in December.
In my view, recent developments are an important reminder of the importance of maintaining an inflation-protection component in an investment portfolio, given that inflation often rises when it’s not expected. There are a variety of asset classes that may offer some level of inflation protection, including inflation-protected securities, real estate, commodities and gold.
1 Source: Bloomberg, L.P., as of Sept. 20, 2018
2 Source: “What We Do and Don’t Know about the Term Premium,” the Federal Reserve Bank of San Francisco, July 20, 2007
3 Source: Bloomberg, L.P., as of Sept. 21, 2018
Blog header image: Billion Photos/Shutterstock.com
All investing involves risk, including risk of loss.
Diversification does not guarantee a profit or eliminate the risk of loss.
The S&P 500® Index is an unmanaged index considered representative of the US stock market.
The CBOE Volatility Index® (VIX®) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices.
The Shanghai Stock Exchange Composite Index is a capitalization-weighted index that tracks the daily price performance of all A-shares and B-shares listed on the Shanghai Stock Exchange.
Safe havens are investments that are expected to hold or increase their value in volatile markets.
In a “no-deal” Brexit, the UK would leave the EU in March 2019 with no formal agreement outlining the terms of their relationship.
A basis point is one hundredth of a percentage point.
The yield curve plots interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates to project future interest rate changes and economic activity.
The value of inflation-linked securities will fluctuate in response to changes in real interest rates, generally decreasing when real interest rates rise and increasing when real interest rates fall. Interest payments on such securities generally vary up or down along with the rate of inflation. Real interest rates represent nominal (or stated) interest rates reduced by the expected impact of inflation.
Investments in real estate related instruments may be affected by economic, legal, or environmental factors that affect property values, rents or occupancies of real estate. Real estate companies, including REITs or similar structures, tend to be small and mid-cap companies and their shares may be more volatile and less liquid.
Commodities may subject an investor to greater volatility than traditional securities such as stocks and bonds and can fluctuate significantly based on weather, political, tax, and other regulatory and market developments.
Fluctuations in the price of gold and precious metals may affect the profitability of companies in the gold and precious metals sector. Changes in the political or economic conditions of countries where companies in the gold and precious metals sector are located may have a direct effect on the price of gold and precious metals.
The opinions referenced above are those of Kristina Hooper as of Sept. 24, 2018. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.
Chief Global Market Strategist
Kristina Hooper is the Chief Global Market Strategist at Invesco. She has 21 years of investment industry experience.
Prior to joining Invesco, Ms. Hooper was the US investment strategist at Allianz Global Investors. Prior to Allianz, she held positions at PIMCO Funds, UBS (formerly PaineWebber) and MetLife. She has regularly been quoted in The Wall Street Journal, The New York Times, Reuters and other financial news publications. She was featured on the cover of the January 2015 issue of Kiplinger’s magazine, and has appeared regularly on CNBC and Reuters TV.
Ms. Hooper earned a BA degree, cum laude, from Wellesley College; a J.D. from Pace University School of Law, where she was a Trustees’ Merit Scholar; an MBA in finance from New York University, Leonard N. Stern School of Business, where she was a teaching fellow in macroeconomics and organizational behavior; and a master’s degree from the Cornell University School of Industrial and Labor Relations, where she focused on labor economics.
Ms. Hooper holds the Certified Financial Planner, Chartered Alternative Investment Analyst, Certified Investment Management Analyst and Chartered Financial Consultant designations. She serves on the board of trustees of the Foundation for Financial Planning, which is the pro bono arm of the financial planning industry, and Hour Children.