Stocks fell on Friday. The decline reflected the Federal Reserve’s action to pull back an emergency program put in place a year ago to ensure bank liquidity. It isn’t needed any longer. But tell investors you are putting a lid back on the cookie jar and they react accordingly. With that said, Friday’s correction was measured and largely limited to financial stocks.
As I often mention intra-quarter, we are in one of those periods of little news. Markets can be quiet, or small factors can take on outsized importance. A spike in Treasury yields, for instance, has an outsized move. The 10-year Treasury this year has been moving upward at a pace of close to 30 basis points per month. From the summer lows last year, the rate of increase per month was less than half that last year. The spike hasn’t occurred in a straight line. When the jump is relatively sharp, stocks fall. When the move flattens out, hopes of accelerating GDP growth takeover and they recover.
But stocks cannot move up in a straight line with yields rising at the current pace for an extended period of time. Should rates rise 30 basis points per month, the rate on 10-year Treasuries would reach 4.5% by year end. That isn’t my prediction, nor is it anyone else’s that I have seen. In 1987, bonds and stocks moved in opposite directions for 8 months before stocks began a 40% correction. This was during a time of strong economic growth. I am not suggesting at all that a 40% correction is pending. Despite the rise in rates to date, real interest rates are still negative and bonds remain an unappealing investment.
With that, free market pricing balances out imbalances. It is said that the cure for high prices is high prices. As prices rise, demand falls and equilibrium is restored. With inflation fears rising slowly, the case for negative interest rates weakens. As the economy gathers strength, the need of negative rates abates. While 4.5% Treasury yields by year end is almost certainly not going to happen, rates could rise toward 2.5% or even 3.0%. Right now, rates are about 1.7%. To get to 2.5% the yield would have to rise at roughly the same pace as it did in the second half of 2020 or even a smidge slower, or about 10 basis points per month. To reach 3%, the rate of monthly increase would be closer to 15 basis points per month or half the rate of gain so far this year.
Market forces alone would make the adjustment quickly. Certainly, Congress passing multi-trillion-dollar stimulus bills provides even more energy. But all this ignores the obvious fact that the Fed is buying $120 billion of bonds every month, helping to keep bond prices high and interest rates low. The rate of increase in yield has accelerated in recent months despite the statements of Fed leadership that it intends to keep buying bonds at the present pace for months or even years to come. But there is a caveat there. Market conditions matter. Right now, markets think the Fed will be forced to raise rates and/or reduce the pace of bond purchases sooner than the Fed officials say they will. Neither side is always right. Don’t fight the Fed remains a proper course. But a change in Fed policy, forced by changing economic trends, would change the ground rules.
For now, however, there are few actual signs of accelerating inflation. Year-over-year data over the next 3 months or so will give a distorted view. A year ago, when most everything was shut down, oil prices were near zero, streets were empty, and most stores and offices were closed. Looking at data today sequentially will give a better picture.
Fears of inflation will recede without hard evidence of rising price pressure. For markets to push rates higher at the recent pace, we will have to start to see wage pressures rise over the summer. On one hand, there are increasing shortages of skilled labor for specific positions. On the other hand, weekly jobless claims are still 3-4x what they were pre-pandemic. What is happening is that some businesses grew and even accelerated during the pandemic, while others lay fallow and still do. The pandemic changed how we live our lives and some of those changes will endure. That means we will do some activities more and others less in the future. That will require reconfiguration. Malls will become repopulated with different businesses. Office buildings will become condominiums. Supply chains, already fractured, will take time to repair. All this will lead to a combination of shortages and excess supply. As noted above, we are already seeing this in the labor market.
These adjustments will affect stocks individually. They already have. There have been winners and losers. Some of the winners may have gotten a bit overvalued. But that’s not today’s topic. Overall, the market is adjusting to change. It always does in a dynamic fashion. Some of the recent winners, like the banks, hit a pothole last week after the Fed ruling. Cruise ships still remain in port. Restaurants are starting to reopen, but at least in the Northeast, to very limited capacity. New York City is allowing theatres to reopen but only can do so under 25% capacity restraints. There is an end to all this, but it has been a bit more challenging all along. Wall Street looks ahead. Unless new virus variants scuttle the recovery, a fear highlighted by renewed shutdowns in Europe, normality, or something close, should return by Fall or even sooner. Stocks won’t rocket ahead at the pace of the past two years. But with an accelerating economy, fears of a sharp correction are misplaced. Having said that, certain assets can be mispriced at any time. Ultimately, fundamentals win and mispriced assets will correct.
Today, Reese Witherspoon is 45. David Portnoy turns 44. William Shatner is 90.
James M. Meyer, CFA 610-260-2220