Where Will Investors Land as Yields Make Round Trip?

U.S. Treasuries marked a roundtrip journey in the third quarter, with the benchmark 10-year yield ending about where it started—just under 1.50%. Yet, rather than signaling higher investor optimism about the economic growth outlook, today’s higher bond yields seem to point toward tightening financial conditions and a rougher road ahead for stocks.

That was not the case earlier this year. The 10-year yield started the first quarter under 1% and ended at 1.74%, as new fiscal stimulus and progress on Covid-19 vaccinations helped fuel robust economic and corporate-profit growth, which also pushed U.S. stocks to new highs.

Then came another shift. Many investors embraced the “growth scare” narrative, amid rising infections from the coronavirus Delta variant. That sparked a dual move toward the safety of Treasuries, which brought yields back down, and the promise of growth stocks, fueling a spike in the value of mega-capitalization technology names.

The most recent rise in Treasury yields marks yet another change in market dynamics. Recent U.S. data on new infections, hospitalizations and fatalities suggest that the worst of the latest wave has passed, tempting some investors to think that markets can pick up where they left off earlier this year, potentially pushing stocks even higher. We’d caution against that view, based on two key signals from the bond market that could ultimately weigh on stock prices through the end of the year:

• Inflation-adjusted, or “real,” yields are rising. Indeed, 10-year real rates rose from a record low of -1.19% in early August to -0.85% at the start of October, as investors brace for tighter monetary policy from the Federal Reserve, particularly given its more hawkish tone in recent weeks.

• Investors are demanding higher returns amid the policy uncertainty. Our market strategists, in particular, have focused on the rise in the “term premium,” which typically reflects the additional returns that bond investors demand for possible policy missteps. This previously low-to-negative term premium has climbed recently, suggesting bond investors may be increasingly concerned, not just about policy tightening, but also by the growing uncertainty in Congress around the debt ceiling, infrastructure bills and deficit financing.

Regular readers know that we expect building headwinds from rising rates and rising cost pressures. Higher rates will compress valuation multiples of stocks—especially those of expensive mega-cap growth names that have become more tied to low rates—and ultimately weigh on broad passive indices, such as the S&P 500, which are dominated by growth stocks. In this environment, investors should consider shifting toward cyclical and value-style stocks and focus on shorter-duration instruments in fixed income.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from Oct 4, 2021, “A Round Trip on Rates.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.