Tech Rout fueled by bond market turn
Largely spooked by rising bond yields, investors continued to sell off equities over the past week, extending losses earlier in the year that surprised many by their speed and severity. Once again, tech stocks led the way. Selling was also extended to sectors like banks and energy, sending the S&P 500 on its worst stretch of decline since the start of the Covid-19 pandemic.
According to analysts, many of these moves are underpinning not only rising yields on ordinary US Treasuries, but also inflation-linked Treasuries, known as TIPS.
Investors pay close attention to TIPS returns as they provide a key indicator of financial conditions and whether the cost of borrowing for businesses and consumers is rising or falling after adjusting for the impact of expected inflation.
Often referred to as real returns, TIPS returns have been deeply negative since the early days of the Covid-19 pandemic, helping to fuel outsized stock market gains by pushing investors into riskier assets in search of better returns. Today, they remain below zero, meaning holders are guaranteed to lose money adjusted for inflation if they hold the bonds to maturity.
Yet they have risen even more than ordinary Treasury bond yields this year – a sign of higher borrowing costs for companies, better forward-looking bond yields and a return to more normal growth and inflation as the Federal Reserve begins to tighten monetary policy Generally bad news for the high flyers of the pandemic rally.
Investors will get fresh insights into the Fed’s mindset this week when the central bank holds its first monetary policy meeting of the year. You will also pay close attention to the corporate earnings of companies like General Electric Co.
, Johnson & Johnson and Microsoft Corp.
, looking for some positive news to reverse multi-week declines for all three major stock indices.
Donald Ellenberger, Senior Fixed Income Portfolio Manager at Federated Hermes, is one of the people behind the rising real yields. He has been a major buyer of TIPS since the early days of the Covid-19 pandemic, steadily increasing them from 4% of his multi-sector bond portfolio in March 2020 to 7% by November of the same year.
Mr Ellenberger was concerned at the time that historic fiscal and monetary stimulus would lead to a rise in inflation – a fear that proved prescient as TIPS surged and CPI soared in 2021, up 7% year-on-year in December rise.
By the end of last year, however, the Fed had changed tack and promised to accelerate the unwinding of its asset purchase program and start raising rates as early as March. In response, Mr. Ellenberger and his team reduced their TIPS holdings from 7% to 1%.
“If the Fed is no longer willing to tolerate above-trend inflation in hopes of creating full employment for all demographic segments of the population, then the upside potential for TIPS relative to nominal government bonds is much less attractive,” he said .
In the past week alone, the tech-heavy Nasdaq Composite Index lost 7.6% and the S&P 500 fell 5.7% — marking its biggest weekly drop since March 2020 — while Bitcoin is down 15%. In the bond market, the benchmark US Treasury yield settled at 1.747% on Friday, up from 1.771% the week before, as nervous investors fled equities for safer assets. Despite opposing currents, 10-year TIPS yields continued to rise – to -0.603% from -0.708% the week before.
Rising Treasury yields aren’t always bad for stocks. In some cases, investors are selling bonds — pushing up yields — because they anticipate more economic growth and inflation, potentially leading to higher interest rates down the road. In this case, real yields could increase. But nominal yields tend to rise more, and the negative impact of higher borrowing costs may be overwhelmed by the improving economic outlook, leading stocks to rise too — as they did after the last two presidential elections.
This year’s selling is in a different category that is less favorable for stocks as investors actively prepare for tighter monetary policy and scale back their bets on inflation.
The gap between ordinary and inflation-linked government bond yields is known on Wall Street as the break-even inflation rate because TIPS holders are compensated when the CPI rises and end up earning the same return as ordinary government bondholders with annual inflation corresponds to the difference between the two returns.
In a 2020 report, analysts at BNP Paribas noted that a 0.3 percentage point increase in the 10-year break-even rate coincided with a 6.6% increase in the S&P 500 and 5.2% in the Nasdaq % correlated. At the same time, the report found that a 0.15 percentage point increase in five-year real yields correlated with a 1.4% decline in the S&P 500 and 4.2% in the Nasdaq.
The big concern for investors is where returns go from here, with growing fears that further gains are likely and likely to fuel further volatility in other assets. Notably, the yield on five-year inflation-linked securities was still minus 1.204% on Friday, well below the real short-term interest rate of about 0.5% that most Fed officials have been estimating as a calming level for the economy to run longer.
Many investors remain confident that both bonds and stocks will stabilize given the strength of the economy and the Fed’s recent reluctance to normalize monetary policy.
“The whole point of a Fed tightening cycle is to slow the economy, and you do that by driving real yields higher,” said Jurrien Timmer, director of global macro at Fidelity Investments. “As long as it’s neat, which I think by and large so far, I think it’s going to be fine.”
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Nevertheless, there are notable exceptions. Value investor Jeremy Grantham, the co-founder of Boston-based wealth manager Grantham, Mayo, Van Otterloo & Co., who predicted the market crashes of 2000 and 2008, said last year that stocks were in a big bubble based on investor belief that this is the case. Interest rates would remain around zero forever. Last week, he built that into a “super bubble” that could end at any moment.
In a note on GMO’s website, Mr. Grantham wrote that it now generally makes sense to avoid US stocks and look for cheaper alternatives in emerging markets and some developed markets like Japan.
“Personally, I also like some cash for flexibility, some resources for inflation protection, and some gold and silver,” he wrote.
Write to Sam Goldfarb at [email protected]
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