Rising Bond Yields Keep World Stocks Unstable

Randall Padilla
February 10, 2018

Stocks recovered modestly, and the Dow was down about 400 points, or 1.6%, later in the afternoon. Or, are we simply returning to a more "normal" cycle of higher yields and higher interest rates?

Next week, coming off one of the most volatile stretches in years, two important readings on US inflation could help determine whether the stock market begins to settle or if another bout of volatility is in store.

The Technology sector continued its decline, which cause the Nasdaq Composite Index to drop by 2.1%.

"Over the last half a dozen of years we have been saying equity valuations can be higher because we are living in a low interest rate and low inflation environment but that's reversing a little bit and that's what we are staring at now", said Art Hogan, chief market strategist at B. Riley FBR in NY.

"This is not the end of the world, but it is uncomfortable", said Rich Guerrini, CEO of PNC Investments.

"A strong currency keeps a lid on inflation, which in turn helps keep interest rates low", she said. "It also helps reduce the amount of interest expense the USA government has to pay on (large and increasing) federal debt". Worries about the bond market are driving another wave of selling on Wall Street.

During its recent rally, the domestic stock market was overlooking the rising bond yields on some "misguided view" about earnings and macro-economic factors being less relevant for the equity market against ample global liquidity, Kotak Institutional Equities said in a recent note. Many equity markets were already in negative territory last week owing to rising bond yields and profit-taking.

In the U.S., recent economic data, including Friday's wage growth and inflation, has been positive.

Equity markets are suffering some competition in terms of investors for the first time in many weeks, he said.

Investors are weighing whether the sharp swings this week are the start of a deeper correction or just a temporary bump in the prolonged bull market.

The S&P 500 last confirmed a correction in January 2016, when it fell 13.3 percent amid concerns about a slump in oil prices.

And the VIX, a measure of market volatility, is near the highest level since August 2015.

"It's not going to be a two-day phenomenon", he added.

"This is how we started, go back to Friday and this is exactly where we were", said Art Hogan, chief market strategist at B. Riley FBR in NY. But it certainly prompts central banks to take monetary action, which reduces liquidity in the system.

It's a big shift from 2017 and the beginning of 2018, when the stock market went the longest period ever without tumbling.

Stocks plunged again Thursday in another market rout despite attempts by Federal Reserve officials to calm nervous investors.

"We had an epic run. There was euphoria because there hadn't been a pullback", said Jeffrey Schulze, investment strategist at ClearBridge Investments.

The market is nervous about new supply coming to the market this year as the Fed not only raises rates but continues its program to buy fewer and fewer Treasury securities, in the unwind of extraordinary easing instituted in the financial crisis.

Treasury bond prices have weakened in the past week-and-a-half as investors adjusted for the likelihood of a stronger U. S.

The Fed planned on raising interest rates slowly this year - just three times in 2018. "New York Fed President William Dudley on Thursday called the stock selloff * a itemscope="itemscope" itemprop="StoryLink" href="/news/terminal/P3UE7C6S972A" class="terminal-news-story" target="_blank" rel="nofollow noopener" *"small potatoes" and said it has no economic implications.

Simply put, when a country's macro-economic situation deteriorates, bond prices fall and bond yields rise, as investors seek more return on bonds to compensate for the risk involved. S. congressional leaders Wednesday reached a two-year budget deal to raise government spending by nearly $300 billion. The compromise, coupled with Republican tax cuts, could lift the federal budget deficit to $1.07 trillion in fiscal 2019, according to Bank of America estimates.

Wall Street anticipates that more government spending will force the Treasury Department to borrow more money by selling additional bonds. Higher rates may raise corporate expenses, which can shrink net income and compress margins.

Still, after a long streak of record-breaking stock market gains, pessimism is growing.

But after shedding over one percent in the opening minutes of trading, the Dow Jones Industrial Average saw a partial recovery to trade a mere 0.5 percent lower approaching midday in NY. The job market remains healthy, as evidenced by a report Thursday that applications for unemployment benefits are at a 45-year low.

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