Actor in a Leading Role: Yields
It’s been a wild ride in Treasury yields this year and it’s not slowing down. There’s a general school of thought that bond markets know things before equity markets do – even if that’s true, the bond market has changed its mind so many times in 2024 that it would be a tough rule to follow in practice. From January through April, Treasury yields rose 70-80 bps, only to fall 90-110 bps between May and early August. Since then, the Federal Reserve signaled and subsequently began its rate cutting cycle, pressuring yields further for a brief period, before economic data came in strong and started driving yields higher again from mid-September to today. Talk about whiplash.
On top of those moves, the most watched curve inversion exited inverted territory in early September and has remained above zero since. This most recent yield curve environment is what’s called a bear steepener – when both 2-year and 10-year yields rise, but the 10-year rises faster (effectively “steepening” the curve and increasing the spread between 2s and 10s).
It’s important to point out that although the environment is called a bear steepener, the name is referring to its effect only on bonds because as yields rise, prices fall. The name has nothing to do with its effect on stocks, in fact it can be rather bullish for stocks depending on the reasons for the steepening.
Cast of Characters
From an investment perspective, particularly in stocks, the yield environment matters and not all environments are created equal. This bear steepening environment, although currently young, has largely been driven by stronger economic data. More specifically, a resilient labor market, inflation that has come down without weighing on growth too much, and a consumer that continues to spend. Expectations for a strong economy have risen while expectations for more aggressive rate cuts have fallen. The commensurate rise in yields reflects this more optimistic economic outlook (i.e., a strong economy can withstand higher rates) and less pressure on the Fed to cut rates more quickly. Naturally, this is supportive of cyclical or economically sensitive sectors. The below chart shows the historical sector performance during bear steepeners (dark blue) and the performance during the current bear steepening environment (light blue). The pattern is playing out mostly as expected with cyclical sectors such as Financials, Energy, and Industrials in the top five. Technology has taken the top spot, led mostly by semiconductors which are a very cyclical component within the sector.
Bearish for bonds has been bullish for stocks, which is generally how the relationship should work. Stocks and bonds should not be closely correlated with one another. That’s the benefit that diversification provides.
Additionally, the fact that we’re seeing life out of sectors besides technology is a good sign for market durability and economic strength more broadly. We just need it to stay that way.
Overhyped Film: Mortgage Rates
The drawback of this environment is that mortgage rates follow the 10-year Treasury yield, and have remained elevated — currently above 7% — pressuring housing activity and driving existing home sales to a 14-year low. We’ve been sitting in a so-called “frozen” housing market of high rates and high prices for a long time, and the exit still seems out of reach. What’s more, the component of mortgage rates driven by uncertainty on things like prepayments (the possibility that borrowers will refinance or payoff the loan early, shown in pink below) has expanded rapidly because of volatility around Fed moves and Treasury yields. This has kept mortgage rates higher than they would be in a calmer rate environment.
As always, there are cross currents and the best we can do is weigh both sides to determine whether there is more opportunity or more risk. In the near-term, I believe there’s more opportunity for stocks to rise further and the economy to remain on stable footing.
The main risks that this environment presents are: the possibility for downside economic surprises when everyone is positioned for the opposite, and the increased pressure that can result from higher yields and borrowing costs. So far, neither of those risks has proven a worthy opponent for the rally in stocks. But both are worth keeping tabs on as data continues to roll in.
Communication of SoFi Wealth LLC an SEC Registered Investment Adviser. Information about SoFi Wealth’s advisory operations, services, and fees is set forth in SoFi Wealth’s current Form ADV Part 2 (Brochure), a copy of which is available upon request and at www.adviserinfo.sec.gov. Liz Young is a Registered Representative of SoFi Securities and Investment Advisor Representative of SoFi Wealth. Her ADV 2B is available at www.sofi.com/legal/adv.
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