Soaring U.S. ‘real yields’ pose new threat to Wall Street stocks

U.S. real yields, the yields investors can expect to earn from long-term government bonds after controlling for inflation, have risen to their highest level since 2011, further eroding the appeal of fixed-income stocks. Wall Street.

The yield on 10-year Treasury inflation-protected securities (Tips) hit 1.2% on Tuesday, up from around minus 1% at the start of the year, as traders bet the Federal Reserve will aggressively raise rates interest and keep them high. for years to come as it attempts to rein in inflation.

The significantly higher yields that safe-haven government debt now offers weighed heavily on the $42 billion U.S. stock market, as investors can find attractive investment opportunities with far less risk. Goldman Sachs strategists said Tuesday that “after a long time” investors buying Treasuries or holding cash would soon earn returns “unattainable” for 15 years.

Real yields are closely watched on Wall Street and by Fed policymakers, providing a gauge of borrowing costs for businesses and households as well as a scale for judging the relative worth of any number of yields. investments.

These real yields fell deep into negative territory at the height of the coronavirus pandemic as the Fed cut interest rates to stimulate the economy, sending investors flocking to stocks and other risky assets in search of yield. . This reversed as the US central bank quickly tightened policy.

“What you see in the higher real rates is the clear expectation that the Fed is going to drain a tremendous amount of cash and liquidity from the market,” said Steven Abrahams, chief investment strategist at Amherst. Pierpont.

The Fed has already raised its main interest rate from near zero earlier this year to a range of 2.25-2.5%. It is expected to raise it an additional 0.75 percentage points later on Wednesday, with further increases taking the federal funds rate to around 4.5% at the start of 2023.

The Fed’s quantitative tightening program, in which it is reducing its balance sheet by $9 billion, is putting additional upward pressure on yields.

The rise in so-called real yields was partly driven by expectations that the Fed will be able to bring inflation closer to its long-term target of 2% in the coming years.

A measure of inflation expectations known as the 10-year break-even rate, which is based on the difference in yield between traditional Treasuries and advice, fell from a high of 3% in April to 2 .4% this week. This would mark a dramatic decline from August’s inflation rate of 8.3%.

“What is important for growth stocks is not whether the peak in interest rates has happened, but the fact that the discount rate will remain higher for longer,” said Gargi Chaudhuri. , Head of iShares Investment Strategy for the Americas at BlackRock. “Over the next 18 to 24 months, all valuations of these companies will continue to be refreshed at this higher level.”

Fast-growing companies that have led the rally on Wall Street since the depths of the coronavirus crisis in 2020 are most under pressure from rising real yields. In effect, higher real yields reduce — or “discount” — the value of the earnings these companies are expected to generate years from now in the models investors use to gauge how expensive stocks are.

Year-to-date, the tech-heavy Nasdaq Composite has fallen 27%. A rally in the second half of the summer was all but erased as expectations of further aggressive Fed action were cemented. The fall in unprofitable tech stocks, which had posted dramatic gains as investors sought high yields, was particularly notable – with a Goldman Sachs index tracking these companies losing half their value in 2022.

“Very expensive, very unprofitable technology companies have been used to discounting their cash flows at a negative rate and now have to readjust to positive rates,” Chaudhuri said. “Because your discount rate is higher, the valuations of these companies will be less attractive because they discount at a higher level.”

Line chart of the 10-year equilibrium rate (%) showing that inflation expectations are falling from their recent peak

Rising real yields may also put more pressure on companies that have taken out leveraged loans, which are made to already heavily indebted borrowers. Interest rates on these loans are usually floating, which means they adjust based on the overall market instead of being fixed at a particular level.

“This is particularly bad news for leveraged borrowers,” Abrahams said.

Ian Lyngen, head of US rates strategy at BMO Capital Markets, added that “sentiment across the economy, in terms of performance of risky assets and perception of the impact on consumers, is closer to real yields than it has been to nominal yields”.

He said: “The logic being that, when adjusted for inflation, real yields represent the clear impact of actual borrowing costs on end users.”

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