Key takeaways
Inflation
The disinflation process has begun.
Interest rates
Lower bond yields will likely follow.
Stocks
Rate-sensitive, early-cycle stocks may benefit.
Are rising or falling bond yields good or bad for cyclical sectors? The answer is yes! While that may not seem like a serious response, it truly depends on the economy-sensitive sector in question at a given stage of the market cycle. As my regular readers know, I think we’re on the leading edge of a stock market recovery — it seems inflation has stabilized, the Federal Reserve may soon wind down interest rate hikes, but I believe the recovery will require the participation of the consumer discretionary sector. So let’s start there.
As an equity strategist, I care about the direction of interest rates — especially the 10-year US Treasury bond yield — because they’re the discount rate for stocks. As we saw through much of 2022, rapid increases in bond yields can dramatically lower the present value of businesses’ expected cash flows. As we’ve seen since October of the same year, however, that process can also work in reverse (i.e., lower bond yields and higher share prices).
Are bond yields heading higher or lower?
One way for investors to get their arms around the prevailing direction of interest rates is by assessing the outlook for the general level of prices in the economy.
Anyone on a fixed income over the past few years understands how accelerating prices for basic necessities — food, rent, medical care, energy, cars, etc. — sap their ability to spend on other more discretionary items. Contrastingly, decelerating prices boost consumers’ ability to spend on discretionary things.
The same principle applies to the bond market. Faster inflation takes a real bite out of fixed coupon payments, thereby reducing the value or attractiveness of outstanding debt issues (Figure 1). Meanwhile, disinflation or outright deflation have the opposite effect (i.e., higher bond prices and lower bond yields).
Figure 1. Peak inflation points to lower bond yields for now
What’s the outlook for US inflation?
In a February 7, 2023, speech, Federal Reserve (Fed) Chairman Jerome Powell said, “The disinflationary process, the process of getting inflation down, has begun…,”1 an official statement that ratifies my favorable views on the general level of prices and bond yields.
In fact, the symmetrical roundtrip of the Institute for Supply Management (ISM) Manufacturing Prices Index — from its trough of 35.3 in April 2020 to its peak of 92.1 in June 2021 and back to contraction territory since September 20222 — suggests a strong whiff of outright deflation in the goods sector.
Powell added that in the non-housing sector, “Services [are] not really showing any disinflation yet.”1 From my lens, however, the annualized 3-month percent change in the Consumer Price Index (CPI) for services excluding shelter has plummeted to a low single-digit pace. Perhaps the “immaculate” disinflation scenario I first wrote about in May 2022 is playing out.
Powell also mentioned that taming inflation “will be a process that takes a significant period of time.” However, I suspect policymakers and investors will be caught off guard by how quickly the disinflationary impulse asserts itself. On a year-over-year basis, headline CPI decelerated for the seventh consecutive month in January 2022, an observation that seems to have escaped recent market commentary.
How do disinflation and lower bond yields affect consumer cyclical stocks?
In a finance-based economy dominated by consumers, the relationship between interest rates and spending is intuitive. When the cost of money or debt rises, consumers think twice about applying for mortgages to buy a house, loans to buy cars, and credit cards to finance spending on other goods and services.
When interest rates fall, however, debt-fueled consumption becomes more manageable, thereby improving households’ financial outlook.
If I’m right about an inflection point in consumer prices, declining bond yields, and a calmer Fed reaction function, those dynamics should support rate-sensitive, early-cycle consumer discretionary stocks (Figure 2).
Figure 2. Declining bond yields have supported rate-sensitive, early-cycle stocks
After a period of normalization and recovery, I’d expect inflation and bond yields to eventually drift higher once again on the back of an expanding economy.
If what’s past is prologue, that stage of the market cycle and change in the direction of interest rates will likely have a different effect on other later-cycle sectors such as financials, industrials, and materials. But that’s a story for another day.
Footnotes
- 1Source: Transcript of Jerome Powell speech, Feb. 7, 2023, The Economic Club of Washington, DC
- 2Institute of Supply Chain Management
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Originally Posted March 3, 2023
How do bond yields affect cyclical sectors in the stock market? by Invesco US
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In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.
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A bond’s yield is the return to an investor from the bond’s interest, or coupon, payments.
A cyclical sector is an equity sector whose price is affected by ups and downs in the overall economy.
The discount rate refers to the rate of interest that is applied to future cash flows of an investment to calculate its present value. It is the rate of return that companies or investors expect on their investment.
Inflation is the rate at which the general price level for goods and services is increasing.
Disinflation, a slowing in the rate of price inflation, describes instances when the inflation rate has reduced marginally over the short term.
Deflation is a decrease in the general price level of goods and services that occurs when the inflation rate falls below 0%.
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