The bond market is signaling some concern over economic growth. That could spell rough waters for stocks in the near term: a potential buying opportunity.
The yield curve has flattened recently. The 10-year Treasury yield has fallen to 1.556% from its 2021 second-half high of 1.702%, hit a week ago, signifying that markets are less optimistic about economic demand and less concerned about the long-term inflation it could bring. Higher inflation, spurred in part by strong demand, means bond investors need higher yields to avoid losing money in real terms on the fixed payments they receive on the debt.
The 2-year yield, meanwhile, has risen to 0.49% from 0.46% a week ago, signaling that markets see the current surge in prices across the economy as lasting enough to force the Federal Reserve to increase interest rates. That would gradually reduce demand and inflation.
Figures released Thursday show economic growth is slowing more than many people expected. In the third quarter, gross domestic product increased 2% from the second on a seasonally adjusted annual basis, while the consensus call among economists surveyed by FactSet had been for a 3.5% increase. Growth in the second quarter was 6.7%.
“Clearly the curve flattening has been significant,” said Tony Bedikian, head of global markets at Citizens Banks. “It’s primarily driven by Fed rate hike expectations that have skyrocketed in the past few weeks.”
The difference in yield between 2-year and 10-year debt has fallen to 1.07 percentage points from about 1.24 points a week ago.
The stock market seems to have taken note of the bond market’s signal. Gains in the
have slowed down. The index is up less than 1% in the past week, while it had gained just under 6% from its level on Oct. 4, the low point in a recent slump, through the close of trading a week ago.
The slowdown in gains could turn into a selloff if the yield curve remains flat for a little while longer. That would signify that markets are more confident that the economic growth outlook is deteriorating.
“If we get to the beginning of the new year and we’re still in a very flat yield curve environment, it’s going to raise some eyebrows that maybe there is an economic slowdown once the Fed eventually does start to hike,” Bedikian said.
That isn’t the most likely scenario. Most on Wall Street expect the yield curve to expand. The 10 year yield—at the least—could easily rise to close to 2% over time, given that long-term inflation expectations are above 2%, according to St. Louis Fed data. That is partly because, although the economic outlook has weakened, it remains positive.
A steeper yield curve would be a good sign for stocks, especially the more economically sensitive, cyclical ones.
Shares of banks and industrial companies have fallen in the past week. The
SPDR S&P Bank ETF
(ticker: KBE) is down just over 2% and the
Industrial Select Sector SPDR ETF
(XLI) has fallen about 0.5%. Those could be worth buying.
“Fade the technical yield curve flattening and buy the dip in cyclical assets,” Marko Kolanovic, JPMorgan’s chief global markets strategist, said in a recent research note. Investors should note the message the bond market has been sending, but take it with a grain of salt.
Write to Jacob Sonenshine at email@example.com
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