Wall St Week Ahead: Falling bond yields bolster equities’ appeal ahead of Fed meeting

NEW YORK, March 17 (Reuters) – Misguided U.S. stocks have gained an unexpected ally in recent days: a historic plunge in bond yields.

Yields on US government bonds fell sharply this week, with some durations marking their biggest declines in decades, as investors bet the Federal Reserve would likely rein in its aggressive rate hike path to avoid exacerbating global tensions. financial system following the failures of Silicon Valley Bank and Signature Bank.

Volatility in fixed income markets has unsettled investors, and lower yields may reflect expectations that the Fed will cut rates on a hit to growth.

At the same time, falling yields have so far been a boon for equities, particularly tech and other large growth stocks whose relatively strong performance has helped support the benchmark S&P 500 index (. SPX). The index ended up 1.4% for the week, with strength in tech stocks outweighing sharp declines in bank stocks.

While the banking crisis has sparked recession fears, “it’s the move in interest rates that’s a…tailwind for equities right now,” said Charlie McElligott, managing director of macro-asset strategy. at Nomura.

Tech stocks vs US bond yields

The short-term trajectory of yields will likely depend on the Federal Reserve meeting next week. Signs that the central bank might prioritize financial stability and slow or pause its rate hikes could pull yields even lower. Conversely, yields could rebound if the Fed signals that cutting inflation – which remains high despite a barrage of rate hikes – will continue to be a job.

“The market is not sure how the Fed is going to look at this,” said Garrett Melson, portfolio strategist at Natixis Investment Managers Solutions.

For now, futures markets indicate that investors are attributing a 60% probability to a 25 basis point rate hike at the March 21-22 Fed meeting, with more rate cuts to follow. later in the year – a sharp turnaround from the hawkish expectations that prevailed earlier. this month.

“For the first time in this cycle of Fed tightening, the Fed must now balance its inflation-fighting credibility with the stability of financial markets,” said Michael Arone, chief investment strategist at State Street Global Advisors.

Treasury yields fell to historic lows after the Fed cut rates to support the economy at the start of the COVID-19 pandemic, fueling a stock market rally that saw the S&P 500 double from its low in March 2020 at some point.

As the Fed began tightening monetary policy a year ago to fight inflation, Treasury yields began to rise, providing investors with an increasingly attractive alternative to stocks. Two-year yields, which recently stood at 3.85%, hit a 15-year high of 5.08% at the start of the month.

The recent rate cut has helped equities regain their appeal, by some metrics. The equity risk premium, or the extra return investors expect to receive for holding stocks rather than risk-free government bonds, has rebounded to its level at the start of January, but still remains close to its level on lowest in more than a decade, according to Refinitiv data.

Other metrics show that stocks remain expensive by historical standards. The S&P 500 is trading at 17.5x forward earnings estimates compared to its historical average P/E of 15.6x, according to Refinitiv Datastream.

US stock market valuation

The rally in interest-rate-sensitive areas such as tech stocks suggests the market expects rates to continue falling as a widely feared recession approaches, Nomura’s McElligott said.

The S&P 500 information technology sector (.SPLRCT) and communication services sector (.SPLRCL) rose more than 5% and nearly 7%, respectively, for the week, supported by strong gains in megacap shares Microsoft Corp (MSFT.O) and Google parent Alphabet Inc (GOOGL.O).

Some investors, however, are skeptical of stock market valuations. Bob Kalman, senior portfolio manager at Miramar Capital, said the Nasdaq 100 (.NDX) is unlikely to trade at more than 25 times forward earnings given current interest rates, below its current level. of 27.3.

“People have this muscle memory to buy mega-cap technology every time they get nervous,” Kalman said. “But the Fed hasn’t backed down from its rhetoric that it knows it needs to overstep because inflation is a much bigger concern in the economy than a few bank failures.”

Reporting by Lewis Krauskopf and David Randall; Editing by Ira Iosebashvili and Richard Chang

Our standards: The Thomson Reuters Trust Principles.

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