The convolutions that the Treasury market sent stocks into over the past few weeks is something investors should probably get used to.
With Covid-19 cases falling, millions of Americans receiving vaccinations each week, and another round of government relief that seems likely, expectations have been raised as to how quickly the economy will grow this year. In early January, economists surveyed by IHS Markit predicted that gross domestic product would increase 4% in the fourth quarter of 2021 over the previous year; now that figure is 5.5%.
Expectations of a stronger economy count as a positive development for companies’ earnings outlook, but are also driving up long-term interest rates, with the 10-year Treasury recently returning 1.41% versus the 0.93% at the beginning of the year. That’s not unusual, as long-term rates generally rise as the outlook for the economy improves, but again, stocks have not tended to be as expensive early in recoveries as they are now.
The S&P 500 is trading at about 22 times analysts’ expected earnings over the next year, according to FactSet, which is close to its highest future price-to-earnings ratio in 20 years. In December 2009, six months after the last recession ended, S & Ps’s forward P / E ratio was approximately 14.
As a result, even relatively modest upward movements in Treasury yields, and thus the relative attractiveness of bonds to stocks, can cause market spasms. This is particularly true for valuable tech stocks that have been among the biggest winners on the market since last spring.
As long as the rise in Treasury yields is driven by an improving outlook for the economy, the stock market can absorb higher rates in the long run. But that doesn’t mean that the process is straightforward. One problem is that instead of gradually increasing, Treasury yields can have long periods of time in which they are relatively stable and then rise rapidly.
Layer in the Federal Reserve. Central bank officials have made it clear that they plan to leave short-term rates near zero and continue to buy Treasuries and mortgage securities until the economy is well on its way to health, but if the Covid crisis really fades, Treasury investors may question the Fed’s commitment to keep buying particular assets. That could lead to bond market paroxysms that shake up stocks as well.
It is not difficult to imagine situations in the coming months in which the Fed fears that the Treasury market is getting ahead and feels the need to calm the waters.
If the economy does improve throughout the year – an eventuality that, of course, depends on the fight against the pandemic going well – the stock market could be in a period of general optimism marked by panic-driven selloffs. . In other words, the recent market displacements could be just a preview of what’s to come.
Write to Justin Lahart at [email protected]
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