Morning Market Commentary:
- The Federal Reserve's rate hikes are nearing an end.
- The central bank has endorsed a peak rate of 5.1% for the year compared with the current 4.5%.
- The two-year U.S. Treasury yield is breaking down through its moving averages.
Excess capital is about to flood back into the stock and bond markets...
Yesterday, we discussed how the current rate-hike cycle has been the most aggressive since 1980. And as a result, 2022 was one of the worst years on record for bond market returns and the traditional 60/40 portfolio.
However, based on what we're seeing in the bond markets and U.S. Treasury yields right now, it seems the aggressive rate-hike cycle is close to an end. And that means the upside potential for stocks and bonds is rapidly improving.
While Monday's focus was 10-year U.S. Treasurys, this morning we'll look at two-year U.S. Treasurys and anecdotal evidence supporting the case for peak interest rates...
So, let's start by looking at the yield on two-year U.S. Treasury bonds. This is an important metric because when both the economic and rate outlooks are more uncertain, individuals and businesses clamor for cash. As a result, short-term borrowing costs rise given the premium. But when that uncertainty begins to ease, those costs will do the same.
As we can see in the above chart, the central bank's rate-tightening cycle caused a stampede for cash. The consequent lack of available funds placed a premium on its value. But that won't last forever. And as inflation showed signs of peaking back in June, investors began to breathe a sigh of relief and grow more optimistic in their rate-hike outlook.
The two-year U.S. Treasury yield peaked in early November 2022 at 4.72%. Ever since it has been steadily easing and is now down to 4.18%. That's a signal rate sentiment is improving.
Now, look at the same chart with respect to the 200-, 100-, and 50-day moving averages of the two-year U.S. Treasury.
Again, we can see the current yield is breaking down through its moving averages – just like the yield on the 10-year U.S. Treasury is doing. The difference here, however, is that the two-year U.S. Treasury yield peaked a little later because investors were more certain about the long-term outlook. Consequently, it's slower to break down.
And then there's the recent Fed commentary...
Last week, policymakers signaled rate hikes are reaching their peak – just as we noted earlier. Vice Chair Lael Brainard said inflation growth is slowing and that it's appropriate to slow the pace of rate increases as a result. She also noted monetary policy is closer to a "sufficiently restrictive level."
The sentiment was echoed by Boston Fed President Susan Collins. She said a measured approach to rate hikes makes more sense, noting that it takes time for the economic fallout of these increases to be felt. But she remarked that once the federal funds rate creeps just over 5%, it would be appropriate to stop (it's currently at 4.5%).
Those two comments are Fed speak for "we're about to hit peak interest rates."
If big-money investors think interest rates are about to rise rapidly like we saw last year, then why be in a rush to put money to work? Because of the inverse relationship between bond prices and yields, rising rates will encourage the selling of low-yielding bonds in hopes of reinvesting in assets with higher returns down the road.
It's a similar story for stocks. If interest rates are going straight up, it'll cost more to take out a loan or refinance outstanding debt. That's a problem for corporate balance sheets and earnings. You see, when you have to pay lenders more because of higher interest rates, it eats away at your margins. That means companies are less inclined to borrow and spend.
Technology companies are typically associated with investing the most in future growth. That means the road to profitability for those companies is longer... which means the tech sector is often hurt the most by rising rates. Conversely, it will benefit the most when bond yields ease.
The writing is on the wall... The Fed is signaling we're approaching the finish line on rate hikes.
So, institutional and retail investors will clamor to lock in high fixed-income yields as soon as possible. That means the cost to borrow is headed lower as bond prices rally. The change will drive yields even lower, meaning borrowing costs will drop more. That should boost the earnings outlook for corporate America as it'll start to hang onto more of its money.
And as investors start to come to that realization, the cash they're sitting on will be itching to come off the sidelines. After all, it's earning nothing if it's not invested. Slowly but surely, investors will put their money to work, leading to a steady rally in the S&P 500 Index.