A Pre-Meeting Look at Big Fed Hikes and Newly Positive Real Yields

If rates go up, won’t stocks fall? That is the operating theory from many financial commentators lately, which shifted up a gear after Fed head Jerome Powell recently intimated a larger-than-usual 50 basis point rate hike could be in the offing next at tomorrow’s meeting. This, as inflation-adjusted bond yields turn positive for the first time since early 2020’s lockdowns, has many expecting higher yields to hoover money out of stocks. But not so fast. This relationship isn’t what it seems, and we think the proliferation of false fears like this is bullish. Let us explain.

A cursory look back at the last time the Fed hiked a half point—May 2000—suggests watch out: The dot-com crash was just beginning then. However, this came at the end of the Fed’s rate-hike cycle, which notably inverted the yield curve. At the time, many were still in the grip of dot-com euphoria and dismissed this fundamental economic negative. Ignorance, it turned out, wasn’t bliss. Circumstances today are different. The Fed has only begun embarking on rate hikes. The yield curve—properly measured—isn’t near inversion. The spread between 3-month and 10-year Treasury yields stands above 2 percentage points.^[i] That is its widest since 2016, thanks in part to the 10-year’s widely derided trip above 3.0%.

We think the mid-1990s’ rate-hike cycle is a more relevant comparison. From February 1994 to February 1995, the Fed raised the fed-funds target rate from 3% to 6%. This cycle featured three half-point hikes and even one three-quarter-point hike. Judging by today’s pundits, you might think such aggressive “tightening” would have sunk stocks, but it didn’t. The S&P 500 rose 0.7%.^[ii] Nothing to write home about, admittedly, but consider a couple points. One, 1994 was a midterm year that featured unusually high uncertainty, coming amid former President Bill Clinton’s first term—and then-First Lady Hillary Clinton spearheading controversial healthcare reform that had many investors on edge. As we have noted, stocks often grind early in midterm years. But the S&P 500’s worst drop that year was just -8.5% from a February 1994 high to its April low.^[iii] Two, stocks thereafter recovered—and then some—even as the Fed hiked rates through early 1995. Reacting to the hikes as if they were bearish could also have set you up to miss 1995’s 37.6% full-year rally.^[iv]

Another concern cropping up recently: 10-year inflation-adjusted Treasury rates—“real yields”—have risen above zero, which many think is bearish. Such Treasurys adjust their principal value by the amount the Consumer Price Index rises, hence their name: Treasury Inflation-Protected Securities (TIPS). Because TIPS yields reflect investors’ average inflation expectations over their respective maturities, many consider them the market’s measure of real yields—what nominal benchmark Treasury rates would be after (expected) inflation.

The reason real yields’ flipping positive is allegedly worrying stems from so-called “there is no alternative” or TINA thinking. As the theory goes, negative inflation-adjusted bond yields are the only reason many people buy stocks. Because investors want positive real returns, when low-risk bonds don’t offer them, there is no alternative except to buy riskier stocks. Supposedly, then, once bonds sport positive real yields, there will be an alternative. Flows will flip.

But is it true? Not in practice. Real yields were positive through the mid-2000s and didn’t send stocks on a downward spiral. The 2007 – 2009 bear market was unrelated, in our view. Heck, real yields fell before and during the early part of it. When real yields turned positive in June 2013 after spending a year and a half negative, the bull market didn’t end. (Exhibit 1) Bear markets and bull markets have occurred with real yields above and below zero.

Exhibit 1: Positive Real Yields Aren’t Really Bearish

Source: Federal Reserve Bank of St. Louis, as of 5/2/2022. Inflation-indexed 10-year Treasury yield, 1/2/2003 – 4/29/2022.

There isn’t a single magic driver that dictates what markets do, whether interest rates (short, long, nominal or real), Fed asset purchases or fund flows. Different markets just have different drivers. Bonds move mostly on inflation expectations. Because most bond payments are fixed over their maturities, their value depends on investors’ expectations of their purchasing power. Shifting perceptions of future inflation will cause bonds’ yields—which move inversely to their prices—to fluctuate.^[v] Stocks care mostly about likely corporate earnings over the next 3 – 30 months versus expectations. Inflation expectations can affect earnings somewhat. But they aren’t central to them.

Liquid markets price in all the same information—but they often react differently because their main drivers differ. So there usually isn’t much reason for investors to get hung up over what bond moves mean for stocks (or vice versa). That many see connections where there aren’t any doesn’t make them true, but it does suggest there could be positive surprise lurking when that dawns on them.