The stock market has gotten hit lately, as the Federal Reserve begins to tighten monetary policy. The worst may be over now.
The S&P 500, Nasdaq Composite, and Dow Jones Industrial Average are down 3.1%, 7.6%, and 2.2% from their all-time highs. The main reason is that the market expects the Fed to lift short-term interest rates several times this year to combat inflation, a move that could dent economic growth. Plus, the central bank is considering soon reducing the holdings of Treasury bonds and other debt it bought as it sought to prop up the economy during the pandemic.
That would drag on bond prices, lifting yields. Already, the yield on 10-year Treasury debt has risen as far as 1.8%, a new pandemic-era high. Higher bond yields make future profits less valuable in current terms, putting downward pressure on stock valuations.
Still, there is reason for optimism.
For one thing, there is now a reasonable chance that the Fed might soon pleasantly surprise the market. Prices for interest-rate futures indicate investors see a 90% chance that Fed’s first increase in short-term interest rates will be in March. That means one of two events could unfold: Either the Fed delivers a rate increase, which investors already expect, or it holds off, opening the door to potential stock gains.
“Markets already assume a March hike is likely, suggesting there is now more room for the Fed to surprise on the dovish than hawkish side,” wrote Marko Kolanovic, global head of macro quantitative and derivatives research at JPMorgan.
A slower schedule of rate increases would do two positive things for the stock market. Not only would it ease concern about a slowdown in economic growth, it could keep a lid on the gain in the 10-year Treasury yield. Short-term interest rates have risen so high that bond investors have been less willing to buy 10-year U.S. government debt until its yield offers a substantially higher return than on short-term debt, which pays the investor sooner. If short-term rates rise more slowly, so could long-dated bond yields.
That is what Kolanovic believes will happen.
To be sure, many on Wall Street do expect the 10-year yield to go above 2% soon, given that long-term expectations for annual inflation are above 2%, and bond investors usually demand a higher rate of return than the inflation rate. But the yield could still rise rather slowly.
Already, the 10-year yield has fallen from the 1.8% level twice in the past two trading days. “We don’t think last week’s rapid [bond yield] rise is indicative of how things will eventually play out,” Kolanovic said. “This process should happen in a more gradual way in the coming years and at a pace that risk assets should be able to handle.”
That means earnings growth could bring stocks higher. If bond yields rise slowly and valuations—the multiple of per-share profits that investors are willing to pay for a stock—decline gradually, larger profit streams could bring stock prices upward. Analysts’ forecasts point to 9% annual growth in aggregate earnings per share for companies in the S&P 500 for the next two years, according to FactSet.
Just hang onto the roof if bond yields spike higher in short order.