C.J. Lawrence Weekly – Don’t Fear the Rate Cycle
Last week’s dramatic stock market headlines sounded much worse than the result. The S&P 500 Index finished down 0.9% for the week, and, as of Friday, was up 7.9% on the year. The technology heavy NASDAQ Composite did not fare as well trading off 3.2% for the week but was outperforming most other major equity indices for the year, up 12.8% at the close of the session. The action was similar yesterday with the S&P 500 flat and the NASDAQ Composite down .67%. The attention-grabbing headlines have highlighted the rapid ascent of treasury bond yields which are rising on the back of particularly strong domestic economic reports. The ISM Manufacturing Index reached its highest level since the Index was created, the unemployment rate fell to a 50-year low, and the Consumer Confidence Index reached an 18-year high. The strong reports have pushed treasury bond yields meaningfully higher. The U.S. 10-Year Treasury bond yield closed the week at 3.23%, its highest level since early 2011.
The 10-Year yield looks to have finally found solid footing above 3.0%, giving the Federal Reserve some clear air to maintain its projected schedule of target federal funds rate hikes, without worrying about inverting the yield curve. This evolving outlook may be causing a shift in equity market psychology whereby good news for the economy is now being viewed as bad news for equities. Higher rates are perceived as negative for stock prices. To be sure, higher bond yields create competition for earnings yields on stocks and put downward pressure on valuation multiples.
But an examination of past rate cycles suggests periods of steadily rising rates do not end bull markets. In fact, periods of economic growth and tightening interest rate conditions are often accompanied by strong equity performance. Excluding the high-inflation period of the late 1970’s-early 1980’s, most rising rate cycles have experienced double-digit stock returns. The market may have to endure a digestion period where multiples compress, and earnings rise, but those conditions rarely catalyze a meaningful equity market sell off. Instead, the end of tightening cycles typically ushers in lower stock prices as Fed activity cools an over-heated economy and/or runaway inflation. Excluding the hyper-inflation period of the late 1970s and early 1980s, the average peak 3-month T-Bill yield for tightening cycles is 5.25%. The current 3-month T-Bill yield is around 2.2%. If history serves as a guide, we are much closer to the beginning of the rate cycle than to the end. The rate of change in rates bears watching. But during most previous periods of measured advances in rates, stock investors were rewarded with attractive returns.