The tide has turned. This week, the yield on the 10 year maturity US Treasury moved decisively above 3% to rest at 3.2% on Friday’s close. Yields made their move on Wednesday rising steadily through the rest of the week to end at a level last seen in mid-2011 when they were on their way down. Bottom line, the economy is strong. The most recent estimate for US Q3 GDP growth by the Atlanta GDPNow forecast is above 4% annualized again. Capital expenditures, supported by significant repatriation of corporate cash held offshore, is growing at a near 13% rate. Amazon (having announced raising their minimum wage to $15/hour from the previous $10/hour) is just one of many companies that are paying workers more as well as keeping them busy for more hours in a week. As if the jobs point needed underscoring, the unemployment rate fell below 4% in the August report released Friday to the lowest level in almost 50 years (though the participation rate remains low). It is part of the normal course of interest rates to “ratchet” higher through the middle part of the economic cycle. There has been so much concern about the flatness of the yield curve as the Fed raises rates that it seems ironic that equities swooned later this week as the longer maturities started to reflect higher yields (and thus a bit more steepness).
Always looking out on the horizon and fretting about what can go wrong, traders take the good economic data and the rising yields on longer maturities as a signal that the Fed can raise rates further in December and going forward. And that is true, the Fed will…and when they act in December the yield curve will remain upward sloping (assuming the 10yr stays where it is now) which is a good thing. It also increases the cost for consumers to finance big asset purchases like cars and houses. Rising interest rates also means that there is a higher discount rate to the future cash flows in financial securities (like earnings from a company). Keep the right perspective though. Interest rates are still low by historical standards while wages are rising. In addition, the “real rate” (i.e. after adjusting for inflation) is also exceptionally low. With inflation in August 2018 running about 2.7%, the yield on the 10yr had to rise just to stay solidly positive.
The question comes back to where we are in the cycle. We are in the back half for sure, but that does not necessarily mean that we are at the end. Rising rates do not have to be a headwind to equity market appreciation as long as it is in the context of growth and occurs at a measured pace. Taking a step back from the calendar to look over a longer time frame, we see this recent rise in 10yr yields as the continued trend of higher rates starting in July 2016 when it hit a low just above 1.3%. In the past two years, rates have more than doubled while the S&P 500 has risen 33% cumulatively (or more than 15% per year). It is normal for rates to rise as confidence in economic growth builds and flows through to corporate performance. We are about to start Q3 earnings season and the expectation is for earnings growth to be in the 18%+ range year-over-year (supported by solid mid-to-high single digit revenue growth) which is strong. Also, despite the negative total return year-to-date in investment grade bonds with moderate duration or longer, fund flows continue into fixed income. There may be dips along the way, but the secular upward cycle in equities is not likely over until fund flows reverse out of bonds to create a rising tide in equities.