United States

Long-term rates are falling again



After rising substantially over the past year, yields on longer-term Treasuries have begun to retreat over the past month. And with short-term rates anchored near the zero bound, the moves have led to what’s referred to as a flattening of the yield curve. As shown in the chart, the green line (current) is flatter than the purple line (one month ago), with the flattening more pronounced in the mid-range of the curve (5-10 years) versus the long-end (10-30 years). Generally, when long-term yields fall while short-term yields rise or remain little changed, it suggests market participants are revising down their expectations for future economic growth, inflation, or a combination of the two.

Data suggest the recent move is more closely tied to concerns about the pace of the economic recovery. Emergence of Covid-19 variants has raised concerns among U.S. health officials after the new delta strain led several countries to re-impose social restrictions; including in the U.K., where Prime Minister Boris Johnson postponed a move to drop all remaining restrictions by four weeks. Investors are also contemplating the extent to which persistent labor shortages and ongoing supply bottlenecks could restrain growth. On the labor front, data released from the Labor Department last week showed a record 9.2 million job openings. While the largest proportion of openings is in service sectors such as hotels, restaurants, and salons, those industries reported the strongest job growth; accounting for nearly half of the June payroll increase. This suggests gaps in the labor market could continue to tighten in the coming months, though it is also leading investors to question whether the Federal Reserve (Fed) could be pressured to dial back its support sooner than expected. At the same time, despite rising wage pressures and ongoing supply constraints, investors’ inflation expectations have moderated as the yield on Treasury Inflation Protected Securities (TIPS) has declined more slowly than comparable nominal Treasuries.

While bond markets gyrate around changing economic and inflation expectations, major stock indexes have posted a series of all-time highs this year, leaving valuations at historically high levels. With uncertainty surrounding the labor market, economic growth, inflation, and the global war on Covid-19, some investors are likely taking a wait-and-see approach; shifting money out of equities and into the safety of government bonds. That said, rock-bottom short-term rates and falling long-term rates increase stocks’ appeal since they not only lower companies’ cost of capital, they also increase their implied value (using a lower discount rate to value future earnings results in a higher present value). Further, aggregate year-over-year earnings estimates for the S&P 500 Index in the second quarter increased by the largest amount during the quarter since FactSet began tracking the figure in 2002. That, coupled with a record-high number of constituent firms issuing positive sales and earnings guidance, suggests stocks could see further gains even if price-to-earnings multiples remain stagnant1.

In our view, investors should expect bouts of volatility over the balance of the summer and likely into the fall (a historically volatile season for stocks); but we expect the labor market to tighten over the balance of the year, the Fed to remain accommodative (though a reduction in its asset purchases may be warranted), and sustained above-average economic growth through at least 2022 to support further – if modest – equity gains. Consequently, we would view any market pullbacks as opportunities to rebalance portfolios back to target allocations.

1Holding the price/earnings ratio constant, an increase in earnings implies a higher price

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