Hypersensitive or Hyperparanoid?
We’re obsessed with rates. Sovereign bond rates, policy rates, the direction of rates, and the rate of change in rates.
Are we overhyping the topic? Can we glean any definitive investment guidance on how to position our portfolios based on it?
Just Can’t Get Enough…of the 10-Year?
As U.S. investors, when we talk about “rates” we’re usually talking about the 10-year Treasury yield. It’s largely viewed as a barometer for long-term economic growth and inflation — a gauge for investors as they try to decide what lies ahead.
At least, that’s what it used to be.
It’s still a barometer, but with the Fed currently absorbing 60% of net Treasury issuance, and the fact that our 10-year sovereign bond yields more than many developed sovereigns, Treasurys are attracting foreign buyers at unprecedented levels. There’s also plenty of domestic demand for Treasuries from large institutions that need to manage liabilities and risk.
In fact, the 10-year Treasury auction in August had a bidder participation rate (a measure of appetite for Treasurys excluding the Federal Reserve) of 90.3%–the highest ever. The auction just conducted yesterday had a bidder participation rate of 87.7%–the second highest ever. For reference, the average since the Fed began purchasing assets in Nov. 2008 is 64.7%.
That level of demand keeps a lid on yields, and a lid on yield volatility. And since it’s demand outside the Fed, even when tapering begins, the lid may loosen, but stay on the jar.
Bottom line: movements in the 10-year yield and its absolute level cannot be viewed as direct reflections of economic expectations or monetary policy action.
Calling Sectors Friends or Foes
But can the 10-year yield be used as an indicator of sector winners and losers? Typically, we’d expect financials to do well in a rising rate environment, but the question is how well?
From Nov. 2008, when quantitative easing (QE) began, through today, we found 16 periods when the 10-year yield moved meaningfully up or down (a move of 1.3% to 1.5%). Admittedly, this is a small sample size, but it was important to isolate the QE regime.
We found, unsurprisingly, that when yields rose, financials beat the S&P 500 by an average of 7.4%. When yields fell, financials underperformed the S&P 500 by an average of 8.4%.
But, surprisingly, during the same periods, when yields rose, technology also beat the S&P 500 by 8.7% (and beat it by 4.4% when yields fell). But aren’t rising rates supposed to be bad for technology? Maybe not under this policy regime.
Survey Says: Hyperparanoid
We’re obsessing too much. Rates matter, but they shouldn’t drive too much of your allocation decisions and they can be a poor indicator of equity market behavior. Even though I believe the 10-year yield will move higher through the rest of the year, it probably won’t happen in a straight line. Instead of focusing so much on rates, I think we can be better served by focusing on economic growth, corporate fundamentals, and the state of the global consumer.
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