Inflation, growth and uncertainty can all lead to swings in yields. Which is the guilty party? And what does it mean for investors?
Our Top Market Takeaways for August 18, 2023.
Market update
Cruel Summer
It’s been a fever dream. Stocks took another step back this week as bond yields pushed higher. U.S. 10-year Treasury yields have now risen ~50 basis points (bps) in just the last month, outstripping the peaks we saw back in October and reaching their highest levels since 2007. And it’s not just in the United States—the moves have been global.
Global government bond yields are at their highest since 2008
This chart shows bond yields measured by the Bloomberg Global Aggregate Treasuries Index from 2008 through 2023. In January 2008, yields were 3.16%. In April 2011, they ticked up slightly to 2.35% after falling a bit. In 2015, they were even lower, moving to 0.96% by March 2016 and then moving up a bit to 1.53% in November 2018, finally skyrocketing to 3.35% by August 2023. This is just as high as rates were in June 2008 prior to the Great Financial Crisis.
This begs the question: Why have bond yields been rising?
A lot of stuff can drive bond yield swings, but in the end, it can all be boiled down to three things: 1) inflation, 2) growth and 3) uncertainty. The impact of each ebbs and flows over time.
We think the latter two are the biggest suspects, but let’s go through the line of interrogation for each:
Suspect 1: Inflation
This was the story of 2022. As prices spiked (with headline CPI inflation reaching a zenith of 9.1% year-over-year that June), investors were forced to calibrate and recalibrate just how much the Federal Reserve would have to hike to get inflation in check. With traders, businesses and consumers alike worried about prices continuing to rise, angst over the path of inflation drove much of last year’s moves.
Now, despite the roundtrip in Treasury yields since last October, inflation doesn’t seem like the culprit this time. Sure, costs are still elevated, and some pockets such as rising commodities prices may bring new pressure in the months ahead, but generally, the trend is still one of cooling. Shelter (think: rent) prices have accounted for roughly 80% of inflation over the past year, and leading indicators point to a big deceleration ahead (even if it happens gradually). Consumers also don’t seem all that worried anymore. Expectations for inflation over the next year and beyond continue to fall.
Consumers’ expectations for future inflation have been falling
This chart shows U.S. consumers’ short-term (1 year) and medium-term (5 year) inflation expectations in percentage points from January 2015 through July 2023. In 2015, both short-term and medium-term inflation expectations started at 3% before falling slightly to around 2.5% by January 2016. Short-term and medium-term inflation expectations remained rangebound between 2.5% and 3% until 2020, when both began to rise. By June 2021, short-term inflation expectations had risen to 4.8% and medium-term inflation expectations had risen to 3.5%. Short-term inflation expectations peaked in June 2022 at 6.8%. Medium-term inflation expectations peaked in October 2021 at 4.2%. Beginning in the second half of 2022, both short-term and medium-term inflation expectations began falling, and by July 2023, short-term inflation expectations had fallen to 3.5% and medium-term inflation expectations had fallen to 2.9%.
Verdict: Not guilty.
Suspect 2: Growth
The recession that most have been betting on still hasn’t happened, with the U.S. economy defying the gravity of 525 bps worth of Fed rate hikes. Most who want jobs still have them: The unemployment rate, at 3.5%, remains at historical lows. This has meant that consumers are still eager to spend, even if the pace of that spending ends up cooling and purchases get thriftier. The housing market seems to be stabilizing, and while manufacturing has been worse for wear since last year, some green shoots are starting to sprout.
There are also some signs the U.S. economy could be getting more productive. Most tend to agree that the intense focus on artificial intelligence stands to change the way we live and work for the better, and a renewed focus on revitalizing infrastructure, bolstering supply chains and accelerating the energy transition could likewise safeguard against future threats to growth. But it’s all still a big question of just how much, and when.
So to some extent, investors seem to be accounting for better growth pastures, especially in the United States—but that’s also not necessarily new news. It’s been true for much of this year.
Verdict: Probably an accomplice.
Suspect 3: Uncertainty
We know that interest rates change over time. To account for that variability, investors tend to require more compensation for locking up their money for a longer time versus a shorter time. For bonds, this means demanding a higher yield for bonds that mature in, say, 10 years, than for those maturing in two years.
The catch, though, is that when things feel more “uncertain” than normal, some may demand an even higher yield for longer-dated bonds than they otherwise would. A number of developments seem to be adding some anxiety lately:
- For one, Fitch’s recent U.S. government debt downgrade highlighted the known, but nonetheless long-term concerns over having a lot of debt…and repeated political squabbling over it.
- This came at the same time that the U.S. government said it needed to issue more debt than it expected to in order to pay for all its spending, due to a combination of low tax revenues, high interest costs (from servicing that high stockpile of debt), and more fiscal stimulus. All else equal, more supply of Treasuries can put downward pressure on prices and upward pressure on yields.
- Japan has been one of the lone central banks keeping monetary policy accommodative, while the rest of the world has tightened. But that’s starting to change: In recent months, the Bank of Japan has been loosening its grip on its yield curve control policy (which has kept policy rates in a tight band around 0%). Some are taking this as a sign that one of the last “anchors” for global interest rates is coming loose.
Verdict: Guilty.
In sum:
A combination of better growth and greater uncertainty seems to be behind the moves. Regarding the former, a more resilient economy and higher odds for a “softish landing” could mean that the Fed will keep interest rates “higher for longer,” even if it’s pretty much done hiking. And regarding the latter, given that over the last month, 2-year Treasury yields have moved a fraction of what 10-year yields have (~15 bps versus ~50 bps), it does seem like investors are asking for more (i.e., a higher yield) for the risk of holding longer-dated bonds.
But what does it mean?
With stocks taking a step back when bond yields are on the up, people seem to be questioning how much they’re willing to pay for riskier assets. One way to look at this is through the “equity risk premium,” which is essentially the pickup in return that investors require for investing in stocks over bonds.
Are stocks expensive? Or are bonds attractive?
This chart shows the equity risk premium for the S&P 500 Equity Index in percentage points from 1990 through July 2023. The equity risk premium is calculated by the earnings yield of the S&P 500 minus the yield on the U.S. 10-year Treasury bond. The data series begins near zero in 1990. It remained rangebound between 1.5% and -1.5% through 1998. In 1999, the equity risk premium fell and reached a low point for the entire data series in January 2000 of -2.6%. From there, the equity risk premium steadily climbed and reached a peak of 7.6% in November 2008. From 2008 until September 2002, the data series remained rangebound between 7.6% and 3.3%. After September 2022, the equity risk premium fell and reached 1.1% in August 2023.
That equity risk premium has been declining over the last year or so, and this could mean a few different things:
- On one hand, through higher bond yields, investors could be saying that bonds don’t feel as safe as they used to. This might mean that investors feel like they’re getting rewarded less for taking “more risk” with stocks than they did in past.
- On the other, valuations for stocks today may be skewed by corporate profits in the midst of transition. S&P 500 earnings look like they just troughed in Q2, and while the recovery from here looks promising, it’s still in the process of materializing. To that end, stocks may just look “expensive” because they are starting to price in better growth ahead.
There are probably elements of truth to both camps, but we tend to skew toward the latter. This leads us to two investment conclusions:
1) We still think it’s time to be rebuilding equity portfolios. Our Private Bank clients have been net buyers of equities in just one out of 32 weeks so far this year, leaving many with a lower allocation than they’ve had in years past. What’s more: Not all of the market looks “expensive.” Stripping out big tech, the rest of the market is trading more in line with long-term averages. That offers a potential entry point into areas such as industrials, mid-cap stocks and dividend-growth companies that could outperform, especially in a soft-landing scenario.
The rest of the market looks more attractively valued
This line chart shows the S&P 500 next 12-month EPS expectations, indexed to June 2021. From the start of the series at 100 in June 2021, earnings expectations steadily increased to a series peak of 121 in June 2022. From there, EPS expectations pulled back to 114 in February 2023 before recovering some of those declines to end the series at 118.
2) Bonds look even better to us now…even if the Fed stays “higher for longer.” Higher yields mean bonds offer more income and more protection than they did just a month ago. The stocks versus bonds debate also seems to be hitting a friction point: After stocks sank as bond yields hit a peak yesterday, all that worry in turn prompted bond yields to reverse course and drop in the close (boosting bond prices). While there may yet be spikes in yields, we still think the direction is eventually lower from here.
In all, we think investors should consider both. If bonds are pricing in a better growth outlook, we also think your equities will work for you. If we end up seeing a recession (or even just a growth slowdown), then your bonds can do the work to protect you. That’s all to say, it’s not a bad time to be a multi-asset class investor.
Your J.P. Morgan team is here to discuss what this means for you and your portfolio.
All market and economic data as of August 2023 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.
We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice..
RISK CONSIDERATIONS
- Past performance is not indicative of future results. You may not invest directly in an index
- The prices and rates of return are indicative, as they may vary over time based on market conditions.
- Additional risk considerations exist for all strategies.
- The information provided herein is not intended as a recommendation of or an offer or solicitation to purchase or sell any investment product or service
- Opinions expressed herein may differ from the opinions expressed by other areas of J.P. Morgan. This material should not be regarded as investment research or a J.P. Morgan investment research report.
