Chairman Powell ended the four-day rally in major market averages with a more hawkish tone than he expressed after last week’s Fed meeting when speaking yesterday at a Fed conference. the National Association for Business Economics. He pointed out that the Fed would be successful in containing inflation and that a 50 basis point hike in short-term rates was still on the table, as well as a rate hike above what is considered neutral. compared to a more restrictive policy. That sent equities lower midday and bond yields soared, with the 2-year Treasury rising 17 basis points to 2.14%. This reflects a market that now expects short rates to rise to 2.25% by the end of this year, from 1.75% a week ago.
The good news is that long-term yields have risen as sharply as 2-year yields, which is a positive sign for economic growth, which tells me that the consensus still believes Powell when he says the economy is strong enough to absorb tighter financial conditions. without causing a recession. The 10-year yield jumped 18 basis points to 2.32%, leaving the gap between the two at just 18. Rising long-term yields are weighing most heavily on expensive growth stocks, c That’s why the Nasdaq underperformed yesterday, but I was encouraged by the rally in the S&P 500 late in the day. We don’t want to see 2-year yields rise above 10-year yields, as a reversal was a harbinger of a recession on the horizon.
This leads me to wonder when rising long-term interest rates will become a significant headwind for the broader stock market. We know that the last time Chairman Powell tightened monetary policy and allowed the Fed’s balance sheet to shrink in 2018, it took a 10-year yield of over 3% to cause a near-bear market decline. by 19%. But the nominal rate was not the trigger.
Long-term inflation expectations at the time were significantly lower than they are now, with the 10-year equilibrium rate just 2%. This means that real (inflation-adjusted) yields had to climb over 1% to become a headwind for equities. If we subtract long-term inflation expectations of 2% from the 10-year yield of 3%, we arrive at a real yield of 1%. As you can see in the chart below, long-term inflation expectations rose today from 2% to 3% for obvious reasons.
With the 10-year Treasury yield at 2.3%, this means real long-term yields are still negative, which still favors stocks over bonds as an inflation hedge. Chairman Powell has asserted that the Fed must bring real yields down to zero, at a minimum, in order to tighten financial conditions enough to bring the rate of inflation down. This can happen either by lowering long-term inflation expectations or by raising short-term interest rates sufficiently, which puts upward pressure on long-term rates. The trick is to avoid a reversal and cause a recession.
So that tells me we’re going to see long-term rates climb well above 3% in 2023, and we’ll probably end this year in the 2.5-3% range. This means that real yields could remain negative until the end of this year, supporting the stock market. I think it will take a nominal return closer to 4% to do the kind of damage to equities we saw in 2018 because that would bring real returns closer to 1%, assuming inflation expectations don’t fall .
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