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This week saw another surge in global bond yields, with the yields on 10-year US and Australian government bonds up by around 30 basis points (bps). US yields were given a pump higher this week as September US retail sales smashed expectations and the relentless resilience of the US economy continues to defy expectations of a slowdown.
Given the momentum in yields, as well as concerns around the quantum of debt issuance required by the US government to finance burgeoning deficits, it seems likely that yields could rise further. But the attraction of yields at 5% could also induce investors back into bond markets. In fact, on Wednesday we saw a 20-year US Treasury auction that was very well bid, at rates of 5.2%, in contrast to the 30-year auction of last week, where rates were closer to 4.9% and attracted very weak interest.
Of course, the other factor influencing bond yields is the direction of Fed monetary policy. On Thursday, Fed Chair Powell gave a speech and extensive Q&A at the Economic Club of New York. Here, he stated that inflation was still too high, but indicated that the Fed will wait and see how the data evolves before pulling the trigger on a rate hike, noting that the rise in bond yields is, in itself, significantly tightening financial conditions. The market and most commentators interpreted Chair Powell’s comments as taking rate hikes at the Fed’s November meeting off the table. Another other conduit to tighter financial market conditions, is the equity market. The latest leg of yield increases, which started toward the end of July, and saw US 10-year real bond yields rise by around 90 basis points, could have been expected to undermine US equity market valuations. But the S&P 500 is off its end July peak by only a modest 5%. Based on an almost one percentage point rise in real bond yields, we would have expected the impact on the equity market to be closer to -15%, rather than -5%. What has been holding equity markets up?
Since July, economists have increased substantially their expectations on growth in the US economy for the second half of the year. If we go back to July, Consensus Economics forecasters were expecting year-average growth in the US economy at a below trend 1.6%. Fast forward three months to today and that expectation is now an above trend 2.1%. Such a substantial increase in the economic outlook could be driving a stronger outlook for corporate earnings. Consequently, it is likely that improved corporate earnings expectations are partly offsetting the impact of higher yields on equity prices.
With this backdrop, where should investors be focusing their attention in assessing their outlook for financial markets? In the US, the consumer is king, accounting for 70% of the economy. And households are happy to spend when they have job security, as they do currently with the unemployment rate under 4%. This brings the employment data and the unemployment rate, traditionally data that are considered lagging indicators, to the very forefront of market attention. And of course the inflation data will remain a key determinant of market pricing.
What about traditional forward indicators? Most forward indicators have had a terrible track record of late. Consumer sentiment indexes have been predicting weak consumer spending and business sentiment indexes of both the manufacturing and services sectors have been painting a picture of a deteriorating outlook. None of which have been correct; quite the opposite. Among financial market indicators, many commentators look to the yield curve for forward guidance on the state of the economy. They look for inversions of the curve, signalling a deterioration in growth expectations, followed by a steepening, as investors anticipate that central banks’ will need to interest rates in the face of an economic slowdown. Some commentators would argue that the inversion/steepening has happened this year, but even so, the steepening leg of this narrative has been at the long end, partly driven by strong growth expectations, rather than at the short end in anticipation of rate cuts. The more relevant indicator in the current environment (at least for equities) is corporate earnings as this, along with real bond yields. Again, corporate earnings is traditionally considered a lagging rather than leading indicator.
Unfortunately, the way forward for investors does not rest on a reliance on simple traditional leading indicators. What will be required is a nuanced assessment of the state of the economy and the sustainability of growth in a world of high interest rates and inflation.