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Why are Rising Bond Yields and Inflation Shaking Up Stock Markets?

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What happened last week?

The 10-year Treasury yield exploded higher last week, rising more than 27 basis points at the highs and hitting new one-year highs before declining slightly on Friday.  The 10-year yield rose 17 basis points to finish at 1.50%. Yields spent the first few days of last week rallying in the morning, but then declining and giving back most of those gains during the afternoon, each time thanks to dovish reiteration by Fed Chair Powell at his testimony to Congress. But Powell didn’t speak on Thursday and stronger-than-expected data combined with a weak 7-year Treasury auction led to a spike in yields that saw the 10-year yield briefly rise above 1.60%, before yields dropped back from that level to close near 1.50%. On Friday, yields started modestly lower (down about 5 basis points) but drifted slightly higher to close near 1.50% and again at one-year highs.

Why are higher bond yields causing a decline in bond prices and stocks?

Bond yields are not spiking because the Fed is getting less dovish. Instead, bond yields are spiking because the markets are correctly anticipating a looming expansion in economic growth, and likely, inflation, both of which are negative for bonds. In general, when interest rates rise, bond prices fall. In addition, as interest rates rise, the incentive for investors to hold bonds (which have risk) falls. Investors will take a slightly lower guaranteed interest rate instead of accepting risk for a slightly higher potential return.

As for stocks, Investopedia sums it up as follows: “Inflation—the rise in the price of goods and services—reduces the purchasing power each unit of currency can buy. Rising inflation has an insidious effect: input prices are higher, consumers can purchase fewer goods, revenues and profits decline, and the economy slows for a time until a measure of economic equilibrium is reached.”

Can the Federal Reserve and global Central Banks stop the rise in yields if it accelerates too quickly?

While Central Banks cannot immediately stop a rise in yields, there are a number of levers that can be pulled. First, there’s rhetorical intervention, which is already occurring in Chairman Powell’s commentary from last week’s testimony: “The economy is a long way from our employment and inflation goals, and it is likely to take some time for substantial further progress to be achieved.”

Second, the Federal Reserve can take action to slow the rise in yields by promising to shift the duration of QE bond purchases from the current short-term bonds (2–5-year bills and notes) to 10-year Treasury bonds, thereby increasing demand for the 10-year Treasury and helping to keep the rise in yields more “orderly.”

Should you be worried about inflation?

Inflation was in focus given last week’s rise in yields, and the inflation data largely met expectations. The Core PCE Price Index, which is the Fed’s preferred measure of inflation, rose 1.5% vs. (E) 1.4% and while that’s a bit hotter than expected, it’s nowhere near the 2% level that would cause the Fed to start to worry about inflation. While there are underlying indicators suggesting a looming acceleration in inflation, until the Core PCE Price Index breaches 2.0% year-over-year and keeps going for a period of multiple months, the Fed isn’t going to worry about inflation, and that’s a good thing for stocks as it keeps Fed accommodation in place and should be a mild headwind on Treasury yields.

The bottom line: Investors would be wise to expect volatility in stock and bond markets as global economies work through this phase of the recovery from COVID-19. Our advice to clients is that they remain diversified and deliberate in their commitment to being long-term investors.



Sources: Investopedia, SevensReport


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Andrea L. Blackwelder, CFP®, ChFC, CDFA® and Joseph D. Clemens, CFP®, EA are the founders and partners of Wisdom Wealth Strategies. Their shared passion is simple: to bring financial empowerment, understanding, and peace-of mind to people who wish to improve their financial future, build wealth for their families, and achieve financial independence. Click here to find out more about how you can work with the Denver Financial Advisors at Wisdom Wealth Strategies.

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