Stocks continue to reach record highs, and credit spreads are at record lows. It would seem that, at least for investors in these two asset categories, the economic, profit, and policy outlook could hardly be more favorable. And yet, in the past two weeks Treasury bond yields have recently fallen sharply, defying expectations, and sending investors in search of an explanation. 

Last week, the S&P 500® index added a modest 0.4 percent, but a strong rally on Friday was enough to send the index to another record high to close out the week. And Friday’s strength was concentrated in the cyclical groups, such as financials, industrials, and materials that would be expected to lag their growth counterparts if the economy was in any immediate danger, as the move lower in bond yields might suggest. In fairness, the Russell 1000 Growth index has been outperforming its value counterpart recently, including last week, suggesting some waning enthusiasm for the reflation trade. Over the past seven weeks, growth stocks have climbed 10.5 percent, while value stocks have added a paltry 0.2. That has allowed the growth index to close the year-to-date gap with value, rising 15.2 percent versus 16.6 for the value index. During those same seven weeks, the yield on the ten-year Treasury note has fallen to 1.36 percent from 1.62. 

To a certain extent, the shift in favor of growth stocks over value, and the steady decline in bond yields, has reflected the nuanced evolution of Federal Reserve’s policy discussions. At the April FOMC meeting, the Fed noted that “…many participants commented that various measures of longer-term inflation expectations remained well-anchored.” However, it went further to note that “… if the economy continued to make rapid progress toward the Committee’s goals, it might be appropriate at some point… to begin discussing a plan for adjusting the pace of asset purchases.” At their meeting on June 16, the Fed surprised investors by indicating the possibility that the overnight rate could be raised as early as the second half of 2023, signaling a change from its previous position that the first rate hike would not come before 2024. But the Fed also acknowledged that the recent rise in inflation had been stronger than anticipated. Regarding asset purchases, the FOMC indicated in the minutes for the June meeting that, “… it was important to be well-positioned to reduce the pace of asset purchases, if appropriate, in response to unexpected economic developments including faster-than-anticipated progress toward the Committee’s goals…” 

The Fed Appears to Be Focused on Employment as Inflation Rises 

To be sure, Fed policy has not yet changed. The Fed has consistently said it wants to first see “substantial further progress” toward its goals of average inflation near 2.0 percent over time, and full employment. With inflationary pressures rising faster than anticipated, the focus appears to be on the labor market. But it seems clear that with unemployment at 5.9 percent, the Fed’s objective with regard to the labor market has not yet been met. But the Fed has also pointed out that growth in jobs is being restrained by the coronavirus, confusion over schools reopening, and extended federal unemployment benefits. But, each of those headwinds could diminish significantly once we get into September, resulting in faster progress toward the Fed’s labor market goals, increasing the likelihood that a plan for reducing asset purchases will become more explicit.  

The Bond Market Often Provides Early Warning Signs for Risk 

In addition to concerns about evolving Fed policy, the decline in bond yields has been variously ascribed to fears that economic growth will eventually slow as stimulus fades and the virus proves to be resilient, technical supply and demand dynamics in the bond market, and even seasonal factors. 

But record low yields on high-yield bonds, record low credit spreads, and record high stock prices suggest that economic concerns may be misplaced. Whatever the proximate cause of the decline, especially the rapid descent of just the past two weeks, the bond market has oftentimes provided an early warning system for risk more broadly. That may not turn out to be the case this time, but until there is greater clarity for the decline in bond yields, the move should not be summarily dismissed. 

Important Disclosures:
Sources: Factset, Bloomberg. FactSet and Bloomberg are independent investment research companies that compile and provide financial data and analytics to firms and investment professionals such as Ameriprise Financial and its analysts. They are not affiliated with Ameriprise Financial, Inc.

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In general, equity securities tend to have greater price volatility than debt securities. The market value of securities may fall, fail to rise or fluctuate, sometimes rapidly and unpredictably. Market risk may affect a single issuer, sector of the economy, industry or the market as a whole.

Growth securities, at times, may not perform as well as value securities or the stock market in general and may be out of favor with investors.

Value securities may be unprofitable if the market fails to recognize their intrinsic worth or the portfolio manager misgauged that worth.

There are risks associated with fixed-income investments, including credit risk, interest rate risk, and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is usually more pronounced for longer term securities.

The 10 Year Treasury Rate is the yield received for investing in a US government issued treasury security that has a maturity of 10 years. The two year treasury note has 2 year maturity.

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