It’s supposed to be the battle of, if not this century, then at least this year—the Federal Reserve versus the bond market. But if it is, the Fed isn’t putting up much of a fight. If that remains the case, expect value stocks to remain the market’s winners.
Heading into the Federal Open Market Committee meeting this past week, hopes were running high that Fed Chairman Jerome Powell would do something to slow the rise in bond yields. He did no such thing.
Sure, Powell reinforced the Fed’s pledge to keep its benchmark short-term interest rates near zero through 2023, even as the central bank’s “dots” reflected economic growth of 6.5% in 2021. Little was said about the rise in the 10-year Treasury, which remained calm as Powell spoke.
And then the selling started, with longer-term Treasuries leading the way. The 10-year’s yield had shot as high as 1.76% during the week before ending at 1.73% on Friday, causing the
exchange-traded fund (ticker: TLT) to drop 1%. The
declined by 150.67 points, or 0.5%, to 32,627.97, while the
index fell 0.8%, to 3913.10, and the
slipped 0.8%, to 13215.24, as the most speculative tech stocks got hit.
Not that the Fed would worry about these moves. If anything, it’s probably feeling pretty good about what’s happening. The surging 10-year has taken the wind out of the sails of highly valued companies, such as
(ZM), and quieted bubble talk for now. The amount of inflation priced into 10-year Treasury inflation-protected securities, or TIPS, sits at 2.27%, lower than the 2.5% reflected in five-year TIPS, suggesting that the market accepts that the coming surge in inflation might actually be transitory.
Financial markets, meanwhile, aren’t pricing in a full tightening until 2023, observes
strategist Alan Ruskin, who argues that they would have been calling for higher rates as early as late 2021 under the previous monetary policy regime. “It is a common notion that the markets aren’t listening to the Fed, but fighting the Fed,” Ruskin writes. “The markets are listening, more than it might seem.”
Besides, the Fed’s prime motivation is maintaining financial stability, and right now the rise in bond yields doesn’t appear to be having an impact. In fact, the spread between high-yield bonds and the equivalent Treasuries sits at 3.66 percentage points, 0.2 of a point lower than where it started the year, while spreads between triple-C-rated junk bonds and Treasuries have narrowed by 1.2 points.
“Keep in mind, as long as credit spreads…are tight, the Fed has no real rush to stop yields from rising,” writes Larry McDonald, author of the Bear Traps Report newsletter. “When the selloff turns from a rotation out of tech, to everything selling off, they will take notice.”
For now that doesn’t seem to be the case. Sure, banks had a tough week, with the
ETF (KBE) falling 2.1%, but it looks more like a short-lived response to the Fed’s decision to let a pandemic-related loosening of the regulatory rules expire, not larger fundamental problems. The
ETF (XLE) dropped 7.5%, as oil briefly slid below $60. But that decline, too, looked more like a positioning problem, following a 71% rise since the end of October, rather than anything fundamental.
“Concerns about slowing Asian demand are grabbing headlines, but we see the current soft patch as largely flows-driven, rather than fundamental distress,” writes RBC commodity strategist Michael Tran.
In fact, Thursday’s energy-sector selloff, while brutal, might not have been brutal enough to signal a bigger problem, according to Sundial Capital Research’s Dean Christians. It was certainly painful—every stock in the sector finished the day below its 10-day moving average. But 95% of the stocks were still trading above their 200-day moving averages, a sign of longer-term strength. That combination has happened just 12 times since 1980, and when it did, the sector traded higher six months later 82% of the time, with a median gain of 16%. “The group is short-term oversold in an uptrend,” Christians writes.
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Sure, maybe the Fed eventually capitulates and pulls an Operation Twist out of its back pocket, or finds another way to keep yields from rising. But if Powell continues to back away from this fight, owning banks, energy, and other value stocks is one of the only ways to protect a portfolio.
Don’t fight the Fed, especially if it’s not spoiling for a fight.
Write to Ben Levisohn at [email protected]