Published September 21, 2018
After first popping above 3% back in May, U.S. 10-year Treasury rates returned to that closely-watched level this week, clearing 3% for the second time. The first time rates eclipsed 3% the rally in rates lasted barely a week before investors poured back into bonds pushing yields downward. A push upward in both June and late July failed to clear 3%. Rates have moved quickly in the month of September from 2.85% to 3%+ in a straight shot. This week’s rally finally did the trick, blowing past 3% and setting the stage for perhaps a run to 4%.
Chart 1: 10-year interest rates push past 3% … finally
This new dynamic in the market shifts money around. Sectors that have rallied as interest rates stalled over the summer – namely, real estate and utilities – broke down this week.
Chart 2: Real estate no longer in favor as rates rise
Banks as a group have been treading water all year waiting for interest rates to finally take flight. This week, they again leapt higher as interest rates rallied. Will banks be able to break out and join the market at new highs this time?
Chart 3: Favored bank stock JP Morgan Chase rips higher on rate rise
As we’ve written before, the push-pull dynamic with interest rates is very important to the next leg of the market rally. Historically, rising interest rates are good for the stock market, as long as rates are holding below 5% on the 10-year U.S. Treasury rate. Rising rates, starting from such a low level, indicate a healthy, growing economy with moderate inflation. Rising rates also can indicate money LEAVING bonds and flowing toward stocks – e.g. an investor desire to take more risk in a growing economy. However, when rates get above 5%, inflation has typically been heating up too fast thereby threatening economic growth. Stocks get spooked and are more vulnerable to take a tumble with rates at higher levels.
Additionally, we have the prospect of an “inverted” yield curve, which also can unnerve stocks. This occurs when short-term rates rise faster than longer-term rates – say, 2-year Treasury rates becoming higher than 10-year Treasury rates. This inversion often portends a recession, but often not for as many as 12-18 months. We want 10-year interest rates to rise faster than 2-year rates to avoid the yield curve inversion. Higher 10-year over 2-year rates also create a wider profit margin for banks, who lend at longer-term rates while paying depositors the short-term rate. If 2-year rates are higher than 10-year rates, banks are pressured to pay depositors more than they can make lending the money – an unprofitable scenario for banks.
The stock market is very sensitive to interest rates. After a long, long period of ultra-low interest rates, investors are hopeful rates can normalize back near the 4-5% range for 10-year Treasury yields. This week’s rise above 3% could set the stage for a run to 4%, and a normalization phase of the long, slow economic recovery from the financial crisis.
Investors looked to hold the large-cap S&P 500 index above 2900 this week as trade issues with China continued to swing sentiment. Monday saw the negative of the Chinese trade concerns with stocks selling down -0.6% and the Nasdaq down almost -1.5%. President Trump’s announcement that there would be a trade announcement after the market close pushed the “caution” button for investors to send stocks lower. The announcement proved not as harsh as expected though, setting the stage for a rebound Tuesday. The Nasdaq reclaimed half of its Monday decline with the S&P 500 pulling back to positive on the week with a +0.5% gain. Interest rates moved notably higher with the 10-year U.S. Treasury yield crossing back above 3%, its highest reading in four months. The tick higher in interest rates continued Wednesday pushing financial shares higher to keep the S&P and Dow Industrials positive while the Nasdaq and small-caps posted losses on the day. Stocks rallied Thursday on no new information other than a fourth consecutive down day for the U.S. dollar. The rising dollar has been a thorn in the side of international markets this year. A relaxation in that rise could encourage stock investors globally. The S&P 500 logged a +0.8% rise on the day. Stocks followed that move with a mixed showing Friday. The S&P 500 and Dow Industrials pushed further into record high territory while the Nasdaq and small-cap indexes struggled to join in.
A strong week for financials pushed the Dow Industrials and S&P 500 to record highs while the Nasdaq (which holds negligible financial companies) fell. The S&P 500 (SPY) pushed further above 2900 with a +0.84% advance. The Nasdaq 100 (QQQ) held flat at a -0.15% weekly move. The small-cap Russell 2000 (IWM) slipped -0.57% on the rise in interest rates, which are viewed as hurting smaller companies more than larger ones.
Warm wishes and until next week.