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Spotted: Some Possible Good News In Rising Bond Yields

The Wall Street Journal. logo The Wall Street Journal. 2/22/2018 James Mackintosh

Little matters more to shareholders now than interpreting the message from the bond markets. After the scare at the start of the month that knocked 10% off U.S. stocks, there are indications of possible good news hidden in rising bond yields. Yet the danger remains that massive tax cuts will push up yields to the point where they become bad for shares—and identifying that point is one of the big challenges for investors.

Start with the potential good news. Bond investors seem finally to be anticipating stronger growth in the real economy and a better long-term outlook, a sharp change from the previous assumption that the main effect of U.S. tax cuts would be to boost inflation.

Investors have pushed up real 10-year Treasury yields this month, while inflation expectations finally stopped rising. Bond markets appear to be anticipating more productivity-boosting investment, which would make the tight jobs market less likely to spark inflation.

Even better, real yields on 30-year Treasury inflation-protected securities, the longest-dated U.S. bonds, have also been rising, reversing a decline that set in last summer. Investors are pricing in a better long-term outlook, which would make higher Federal Reserve interest rates possible without damaging the economy—or stock prices.

This good news comes with caveats. It is never a good idea to read too much into a three-week move, even one that has pushed 30-year yields almost all the way back up to where they stood in July. The bond market believing in a better economy doesn’t make it so, either. Finally, the move can be interpreted a different way, as a reward for rising uncertainty about where long-run interest rates will eventually land. If rising yields reflect doubts about secular stagnation, that isn’t nearly as good for stocks as the belief that the post-crisis economic torpor is finally in the past.

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Certainly economists are treating White House forecasts of a productivity renaissance with skepticism. Nathan Sheets, chief economist at PGIM Fixed Income and a former Treasury official, expects the Trump tax cuts to boost economic growth by 0.5 percentage point or a little more for each of the next two years. But he predicts only an annual 0.1 point extra on long-run potential growth, resulting from higher corporate investment.

The huge federal deficits likely to be incurred in the latest U.S. budget come at a time when the jobs market is already tight and there are signs that wage rises may, finally, be accelerating.

The tax cuts add fiscal fuel only poured in this amount into a late-cycle economy twice since World War II, according to Gerard Minack, of Sydney-based Minack Advisors: the Vietnam war spending of the late 1960s and the 1986 Reagan tax cut. In both periods bond yields rose sharply as inflation picked up, while stocks soared, plunged and then soared again before the eventual recession.

The problem for shareholders watching the bond market is that rising inflation expectations are good for stocks until they are bad. One theory for why is simple enough. When investors are worried about deflation, higher inflation reduces the danger and so helps stocks even as it pushes up bond yields. Deflation fears have now gone away, so the question is at what point inflation fears will take over, and rising bond yields be bad for stocks.

One answer is when yields reach the point where they anticipate the Fed actively trying to slow the economy. Higher yields will no longer mean higher profits, leaving nothing to offset the hit to valuations that comes with a higher discount rate.

In economic terms this means bonds being priced for an interest rate above the so-called neutral rate, either because inflation is getting out of hand or because the Fed has made a mistake; either would be bad for both shares and bonds. Fed policy makers estimate the long-run neutral fed-funds rate is 2.8%, about where the 10-year currently stands, but bonds typically offer extra yield to compensate for uncertainty over their term.

Credit Suisse’s chief U.S. equity strategist, Jonathan Golub, thinks the switch happens at a 10-year yield of 3.5%, above which further rises start to be progressively worse for stocks. He derives the number by looking at how stocks performed just on days when yields rose, with a strong relationship since 2014 showing stocks gained less the higher yields were.

In the past the number was much higher, averaging above 7% since 1980, but Mr. Golub says it has dropped because investors, like the Fed, think a weaker economy can’t cope with such high rates as it once could.

Bank of America Merrill Lynch analysts say the “sweet spot” for shares is a 10-year Treasury yield between 1% and 3%, with stocks more likely to fret about rises above that.

Investors shouldn’t get hung up on any precise number, as the turning point is inherently uncertain and shifts with changing beliefs about the economy.

What is more certain is that there’s a regime shift under way. In the past few years investors justified buying shares at very high valuations because bonds looked even worse. As Treasury yields rise, expensive shares will look less attractive—so companies will need the prospect of big rises in profits to maintain their appeal. The more it is real rather than nominal bond yields rising, the better for shareholders.

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