• Investing & Markets

Weekly Market Digest: Interest Rates Spike, Bonds Sink Globally

October 5, 2018 | Craig Birk, CFP®

Q4 got off to a rocky start, with US stocks down 1.3% (VTI) and international falling 2.7% (VEU). Interest rates spiked when Fed Chairman Powell gave an upbeat assessment of the economy and said the central bank may lift rates above the so-called neutral rate of around 3%.

Bonds sank globally, with the US Aggregate Bond market down 1.1% (AGG). The 10 year Treasury yield spiked to 3.19%, the highest since 2011. Tech stocks led declines after a Bloomberg report on Chinese hacking stirred increased trade fears.

Weekly Returns

S&P 500: 2,886 (-1.0%)
FTSE All-World ex-US (VEU): (-2.7%)
US 10 Year Treasury Yield: 3.19% (+0.13)
Gold: $1,203 (+0.6%)
EUR/USD: $1.152 (-0.7%)

Major Events

  • Tuesday – Amazon announced it would raise its minimum wage to $15, but later said it would come at the expense of some bonuses and equity compensation. Retail stocks fell.
  • Tuesday – Tesla said it met its production target for the Model 3 but is struggling to deliver the cars in a timely fashion.
  • Thursday – Bloomberg released a report saying Chinese spies hacked America’s technology supply chain. Apple and Amazon refuted the claims.
  • Thursday – The US DOJ announced an investigation into Dansk Bank and massive money laundering in Europe.
  • Friday – Mattress Firm filed for Chapter 11 and said it may close up to 700 stores.
  • Friday – The US added fewer jobs than expected but the unemployment rate fell to 3.7%, the lowest since 1969.
  • Friday – Brett Kavanaugh gained enough support to seemingly ensure confirmation to the Supreme Court.

Our Take

For the past six years, everyone has been expecting interest rates to rise. They didn’t, until now. For perspective, so far this year Three Month Treasuries are up from 1.29% to 2.16%. Ten Year Treasuries are up from 2.46% to 3.19%. This kind of move is meaningful, but not dramatic. The question is of course, what comes next and what to do about it.

On the bond side, the US Aggregate Bond market has generated a -2.6% total return for investors this year. No one invests in bonds to lose money, so this has naturally been disappointing. It is also somewhat uncommon. Since 1926, bonds have only lost money in 15% of years according to Vanguard. It gets better if you think a little longer term. A decent estimate for five year forward annualized returns is current yield, which is now a little over 3%. That’s higher than cash and bonds also continue to provide low correlation to stocks, which makes them a great diversification tool, although this week both bonds and stocks were down.

In the equity market, reactions to higher rates were schizophrenic this week. On some days, rate sensitive sectors like utilities were down, and on others they were up as investors sought safer assets. Big picture, higher rates are bad for stocks because they make bonds a more compelling alternative. The forward looking PE on the S&P 500 is around 17. That equates to an earnings yield of around 6%. This is still fairly attractive given current interest rates. To keep the same spread, a further 1% increase in rates would require a forward looking PE of closer to 15. That means either stocks would have to drop by around 12%, or earnings could grow around 12%, or some combination.

The truth is no one knows where rates are headed and there are many more factors impacting stock prices beyond interest rates. Lately, earnings have been growing at a phenomenal rate, and they will likely continue to be the main driver of stock prices one way or the other.

Many investors have lost money over the past decade betting on higher rates. We feel fortunate to follow an approach that doesn’t rely on making that guess.

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