Persistent Fed Stance on Inflation Explains Bond Investors' Jaundiced View
The recent backup in treasury yields and mortgage rates should be on every investor’s radar right now.
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One of the most contrarian things about the market rally over the past three months is that the direction of interest rates hasn’t upset the apple cart quite yet.
The central bank has now cut the fed funds rate by 100 BPS, starting with a half-of-1% reduction at the FOMC meeting in mid-September. Intriguingly, the yield on the 10-year treasury, rather than dropping, has moved from just over 3.6% at the first relaxing of monetary policy just over three months ago, to nearly 4.6% at of Thursday's market close. Despite the choppiness over the past few weeks, the market is significantly higher, despite the back up in treasury yields. The S&P 500 has risen nearly 8% since Chairman Powell granted investors an early Christmas gift.
I am having trouble recalling when the federal funds rate and yield on the 10-year treasury diverged to such a significant degree in such a short period of time. I do remember the last time the yield on the 10-year moved up significantly, as the central bank launched their most aggressive monetary policy since the days of Paul Volcker early in 2022. The results were not good as the S&P 500 dropped nearly 20% in 2022 with the NASDAQ losing around a third of its value in what was a rotten year for investors.
Given that, equities have held up remarkably well to this point as yields have shot higher. However, if yields rise or even remain near current levels, I fear the markets will not be so kind as we get into 2025. Rising yields in the face of a 1% decrease in the fed funds rate also tells me that the markets are not nearly as confident as the Federal Reserve that the inflation genie has firmly been put back into her bottle. Given these central bank mandarins persisted in stating inflation was "temporary" and "transitionary" through most of 2021, one can hardly blame bond investors for their jaundiced view.
In addition, the country’s massive federal debt and large fiscal deficit is likely to remain a substantial headwind for hopes that treasury yields will fall significantly in the quarters ahead. At some point in the near future, that could become quite problematic for equity investors, especially given the already-stretched valuations of the overall market, utilizing many historical valuation metrics.
My regular readers know that I have urged extreme caution around the homebuilder- and housing-related stocks since that September FOMC meeting. After initially rising, those sectors have been hit quite hard lately.
D.R. Horton, Inc. DHI is down more than a quarter from its recent highs and Toll Brothers TOL has also fallen by more than 25% over the past month. With mortgage rates at their highest levels since July, those dips are not buyable yet, in my opinion. Margins across the industry are likely to be increasingly hit by mortgage rate buy downs, free upgrades and other incentives that will be needed to be utilized to move inventory. The sector also may face headwinds from a reversal in immigration policies given a good chunk of its labor force is "undocumented," to put in delicately.
More importantly, if treasury yields and other interest rates across the economy remain elevated despite reductions in the fed funds rate, other sectors of the market could see the same type of selloffs that have recently hit housing-related stocks.
At the time of publication, Jensen had no positions in any securities mentioned.
