Plunging bond yields boost stocks’ allure ahead of Fed meeting

By Lewis Krauskopf & David Randall

NEW YORK (Reuters) – Whipsawed U.S. stocks have gained an unexpected ally in recent days – a historic plunge in bond yields.

U.S. government bonds yields plunged steeply this week. Some durations saw their largest drops in decades. Investors bet that the Federal Reserve would slow down its rate hikes to prevent financial system stress from being worsened by the failures at Signature Bank and Silicon Valley Bank.

Investors are worried about the volatility in fixed-income markets. Falling yields could reflect fears that the Fed will reduce rates to compensate for a drop in growth.

The drop in yields has been a boon to equities so far, particularly tech and other large growth stock whose strong performance helped support S&P 500. The index gained 1.4% in the last week. This was due to strong performance in technology stocks versus sharp declines in bank share.

Recession fears have been sparked by the banking crisis “it’s the interest rate move that’s a … tailwind for stocks right now,” Charlie McElligott is Nomura’s managing director for cross-asset macro strategies.

The Federal Reserve meeting next week will be crucial for the direction of yields in the near future. Yields could fall further if the central bank signals that it may prioritise financial stability and slow down or halt its rate increases. Conversely, yields could rebound if the Fed signals that bringing down inflation – which remains high despite a barrage of rate increases – will continue to be job one.

“The market is not quite sure how the Fed is going to look at this,” Garrett Melson, portfolio strategist for Natixis Investment Managers Solutions, said:

For now, futures markets indicate that investors are assigning a 60% probability of a 25 basis point rate increase at the Fed’s March 21-22 meeting, with rate cuts to follow later in the year – a sharp turnaround from the hawkish expectations that prevailed earlier this month.

“For the first time during this Fed tightening cycle, the Fed now has to balance its inflation-fighting credibility with financial market stability,” Michael Arone is the chief investment strategist at State Street Global Advisors.

The Fed cut rates at the start of the COVID-19 pandemic to support the economy. This triggered a stock market rally which saw the S&P 500 more than double its March 2020 low.

Treasury yields rose as the Fed tightened its monetary policy last year to reduce inflation. Investors now have an attractive alternative to equities. The 2.85% two-year yield reached a record high of 5.08% earlier in the month, a level that was unprecedented for this time in 15 years.

Some metrics show that stocks are now more attractive due to the recent fall in rates. According to Refinitiv data, the equity risk premium (or the extra return investors get for holding stocks rather than risk-free bonds) has recovered to where it was in January, but is still near its lowest level in more than a decade.

Other metrics indicate that stocks are still expensive by historical standards. Refinitiv Datastream shows that the S&P 500 trades for 17.5 times its forward earnings estimates, as opposed to its historical average P/E at 15.6 times.

McElligott, Nomura’s Nomura analyst, said that the rally seen in tech stocks and other interest-rate sensitive areas like tech stocks indicates that investors expect rates to continue falling when a much-feared recession approaches.

S&P 500’s information technology sector and communication sector rose by over 5% and almost 7% for the week, respectively, thanks to strong gains in megacap stocks Microsoft Corp. and Google parent Alphabet Inc.

However, not all investors are convinced that stock valuations are accurate. Miramar Capital’s senior portfolio manager Bob Kalman stated that the Nasdaq 100 should not trade at more than 25x forward earnings, given current interest rates. This is below its 27.3.

“People have this muscle memory to buy mega-cap tech whenever they get nervous,” Kalman stated. “But the Fed hasn’t backed off its rhetoric that they know they must overshoot because inflation is a much larger concern in the economy than a couple of bank failures.”

(Reporting by Lewis Krauskopf, David Randall; Editing By Ira Iosebashvili & Richard Chang

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