The recent rise in the yields of the two-year and ten-year Treasury notes can be attributed to several factors, and it has different meanings in financial markets, confusing many investors:
Economic Growth Expectations: Investors anticipate more robust economic growth, often leading to higher yields. When the economy is expected to grow, investors demand higher returns on their investments. The stock market rises if higher bond yields are associated with accelerating economic growth. Stocks and yields move up together.
Inflation Concerns: Higher inflation expectations typically lead to higher yields as investors seek compensation for the decreased purchasing power of future interest payments. In this scenario, volatility increases in the stock market. However, if the Federal Reserve (Fed) is forced to increase rates to control inflation aggressively, the economy may enter a recession, causing the stock market to collapse. Stocks fall, and yields rise. Here, they move in opposite directions.
Federal Reserve Policies: The Federal Reserve’s stance on interest rates and monetary policy can significantly impact Treasury yields. If the Fed signals potential rate hikes to combat inflation, yields tend to rise in response. Again, in this scenario, volatility in the stock market is the first symptom to arise.
Market Sentiment: Overall investor sentiment and confidence in the financial markets can increase yields. When investors feel optimistic about the economy, they may move away from safer investments like Treasuries to more aggressive assets seeking higher returns, causing bond prices to drop and yields to rise. In this case, Market Sentiment is associated with the economic growth expectation mentioned above.
Any of these individual factors or a combination of them may have contributed to the recent upward movement in Treasury yields. The reality is that bond yields are increasing, and the Fed lowered the Fed Fund Rate by 50 bp on September 18. Bond investors are signaling a different message to the Fed. Although the unemployment rate remains at 4.1%, Friday’s jobs report was weaker than expected. In the mind of equity investors, this opens the possibility of a 25 bp additional rate cut in the next Fed meeting on Nov. 6 and 7. The presidential election day is November 6, and the interest rate announcement is November 7.
The chart below shows the yield of the 2-year Treasury Note, which made an impressive jump in early October and continued its upward journey throughout the month. The same behavior can be observed in the yield of the 5-year and 10-year Treasury Note, and the 30-year Treasury Bond, which are not shown here. The spread between the 2-year and the 10-year yield is now back to normal, with the former being lower than the latter. This indicates that bond investors are not concerned about an economic recession. Although some economic data shows that the economy is cooling down. Therefore, we can conclude that the uptrend in yields is not related to economic expansion but the reacceleration of inflation. As I have been saying throughout the year, this puts the U.S. economy in the last quarter in Phase III of the economic cycle, where GDP decelerates, inflation accelerates, and volatility is king. Therefore, portfolios should be adjusted to benefit from reflation.
This week, Nov. 4 through 8, we’ll have quarterly earnings reports from Google (GOOGL), Advanced Micro Devices (AMD), Microsoft (MSFT), Meta (META), Apple (AAPL), and Amazon (AMZN). The results of these six mega-companies may give a good sense of short-term stock market direction. Volatility ($VIX) remained high in October, with Friday’s closing at 21.88. To put it into perspective, bull markets usually occur with $VIX below 18-17. However, the most bullish historical period of the year just started. It runs from October 27 through January 18.
All these can confuse many investors and may even prevent them from making informed decisions, which is never a good idea. This is where it is essential to have a trading or investing plan and follow it. As I mentioned throughout the year, we are bullish mid- and long-term and remain cautiously bullish short-term due to higher-than-desired volatility.
Thursday’s heavy selling caused some technical damage to the major indexes. The S&P 500 Index pierced the 20-day EMA and almost touched the support of its 50-day MA. On Friday, the index opened higher but closed at the bottom of the day’s trading range at 5728.80. Although this is normal pull-back behavior in any uptrend, technically speaking, it would be important for the index to recover the 20-day EMA, now at 5782.58. Conversely, piercing the 50-day MA now at 5701.74 and closing below it would only add short-term volatility and anxiety to investors without an action plan. In this scenario, the index may drop to test support at 5600, and if it does not hold, the next line of support would be 5500. See the chart below.
Currently, subject to change as new data becomes available, our worst-case scenario shows S&P 500 support in the 5100 to 5200 range, indicated as “Main Support” in a red-shaded box. It would be a -9.00% to -11.00% correction from its peak in October. Is it possible that the S&P 500 drops to the 5100/5200 area during November? Sure, anything is possible in a problematic world such as ours. But is it probable? No, not in our opinion, as long as inflation does not become out of control and geopolitical conflicts do not escalate, becoming more of a worldwide conflict or black swan event.
I remain cautiously optimistic about the presidential election: Tuesday’s election could lead to market volatility, especially if there are significant changes in economic policies. As I mentioned in my last article, U.S. presidential elections have been known for two dominant political parties, center-right and center-left, on social issues but with similar economic interests and capitalists without hesitation. Not this time. The economic policies of each party are far apart and may deliver very different results.
