Stocks Remain a Prisoner of Interest Rates

  • The stock market is following the bond market like a puppy. Rates down? Buy growth stocks. Rates up? Buy reflation stocks.
  • U.S. growth estimates are rising, but they are falling in other developed markets.
  • Unless something changes, rates are probably going nowhere.

The economic experience in the U.S. compared with Europe and much of Asia is very different. Although there are some risks of an increasing infection rate in the U.S. after Spring Break, a rapidly growing vaccination effort rate is mitigating that risk and confidence is building. Most are very surprised at the resiliency of the U.S. economy and growth estimates are rising. Meanwhile, Europe can’t make up its mind whether to lock down again, or not, and projections for economic growth are headed south. For now, that has helped to at least temporarily reverse the longer term down trend in the dollar.

It has also served to increase the yield spread between U.S. Treasuries and other sovereign (government) debt. The result is that for the first time in several years, foreign investors have the opportunity to pick up yield with a hedged carry trade. (See chart at top of the following page.) Allow us to explain. A carry trade is when investors in one country, sell their currency, buy U.S. dollars, and then invest in U.S. Treasuries in order to earn a higher yield than they could earn at home. Of course, that would expose them to currency risk, but even after hedging out that risk, they can still earn more than at home. That demand should help to keep a lid on Treasury rates in the near term. But be aware that if Europe gets a handle on COVID over the next few months and growth estimates begin to rise there, this dynamic can reverse quickly, which gives the opportunity for upward pressure on U.S. rates to return. Bottom line, we look for interest rates to find their footing after a bone rattling rise over the last few weeks. This improves the chances for a cooperative stock market in the interim as the stock market typically frowns on bond market disruption.

In addition, the yield on the 10 Year Treasury Note is now back at a level in excess of the dividend yield on the S&P 500, which may also bring in some bond buying. (See chart below.)