From online sales to housing starts, investors continue to be flooded with a never-ending stream of numbers. But these days there’s one that is clearly driving market action beyond all others: the climbing yield on the 10-year Treasury note.
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Always a closely-watched figure, the rate on benchmark U.S. government debt is playing an even more pronounced role of late as Wall Street worries about Federal Reserve policy and its impact on the real economy.
“Everything the Fed has done has been to suppress interest rates,” said Peter Boockvar, chief market analyst at The Lindsey Group. The recent jump in yields “is a sign they are losing control of the bond market. That is not good for stocks,” he said.
The Dow Industrials are poised for their fifth consecutive red day, their longest slump since late September, just as the 10-year Treasury yield climbs to levels unseen since mid-September.
So what’s driving investors away from bonds? Mostly, it’s been evidence of economic improvement, which has led some to bet the Fed could dial back its bond-buying stimulus program earlier than anticipated.
The positive economic indicators include reports on Thursday revealing the U.S. economy (thanks largely to inventory builds) grew at its fastest pace since early 2012 and unemployment claims fell below 300,000.
Other upbeat economic reports include the biggest spike in new home sales since 1980, the fastest manufacturing activity expansion since April 2011 and stronger-than-expected private payroll growth of 215,000 jobs in November.
“As market participants are waiting for the Fed to taper, every data point receives greater scrutiny,” said Kristina Hooper, U.S. investment strategist at Allianz Global Investors.
Bond Markets Display Impatience
While Hooper said the bullish stream of data has led some to brace for an imminent Fed move later this month, Allianz still believes it’s far more likely to see action next year.
“We have no idea what the Fed is thinking so they’re only guessing and in essence flying blind. It’s nowhere near an exact science, but we have a nervous market,” she said.
The fixed-income world doesn’t seem to be waiting for policymakers and equity investors to make up their minds.
“The bond market is tapering for them,” said Boockvar. “The bond market is the transmission mechanism of everything the Fed is trying to accomplish.”
The 10-year Treasury yield climbed as high as 2.874% on Thursday in response to the GDP and unemployment reports. It had been sitting just above 2.5% as recently as six weeks ago.
While the S&P 500 remains very close to its all-time high, the move higher has been muted, at least momentarily, by the bond market action.
Peter Kenny, former managing director at Knight Capital Group (NYSE:KCG), said higher rates will eventually prompt a rotation out of equities. “People are anticipating that. It may, at some point, become a self-fulfilling prophesy,” he said.
Impact on Real Economy
To be sure, bond yields remain at historically low levels and the market response hasn’t been as dramatic as when concerns about dialing back QE first engulfed Wall Street back in May.
“Yields had been artificially suppressed for years. They’re realizing we’re not in an emergency situation that deserves historically low yields. It’s normalizing,” said Boockvar.
Still, all of this trickles down into the real economy in the form of higher borrowing costs, specifically in terms of mortgages. The miscommunication between the Fed and investors over the summer slowed down the real-estate market as prospective buyers were spooked by higher mortgage rates.
According to Freddie Mac, a 30-year fixed-rate mortgage averaged 4.46% over the week ended Thursday, up from just 4.29% the week before and 3.34% a year ago.
The higher borrowing costs have helped to spark a 17.5% drop in mortgage refinance applications to 12-week lows and leaving purchases down 4.1%.
“While some argue that it’s no big deal that rates are rising because it’s due to a better economy, it certainly (is) not good for the very important industry of housing in a market medicated on cheap money,” Boockvar said in a recent note to clients.
'Surgical' Central Bank
That thinking helps explain why the Fed decided to stay on the sidelines during the widely-anticipated September taper that failed to materialize.
Hooper said Fed officials are “certainly cognizant” of rising yields, but market action is “less likely to temper the Fed’s behavior” this time around. Instead, she expects the central bank to be “very surgical” by initially focusing on dialing back on government securities before mortgage-backed securities, which are seen as more important to the real economy.
Like many firms, Allianz is modeling for Treasury rates to continue to rise as the Fed takes its foot off the QE pedal and the economy heals. Allianz sees the yield on the 10-year Treasury note climbing to 3.25% and the S&P 500 touching 1900 by the end of 2014
“Our view is that rates going up is inevitable. But that shouldn’t stop investors. In fact, it should be a catalyst for investors to move out on the risk spectrum,” said Hooper.
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