{"id":186225,"date":"2023-03-07T10:20:00","date_gmt":"2023-03-07T15:20:00","guid":{"rendered":"https:\/\/ibkrcampus.com\/?p=186225"},"modified":"2023-03-07T12:35:48","modified_gmt":"2023-03-07T17:35:48","slug":"how-do-bond-yields-affect-cyclical-sectors-in-the-stock-market","status":"publish","type":"post","link":"https:\/\/www.interactivebrokers.com\/campus\/traders-insight\/securities\/macro\/how-do-bond-yields-affect-cyclical-sectors-in-the-stock-market\/","title":{"rendered":"How Do Bond Yields Affect Cyclical Sectors In The Stock Market?"},"content":{"rendered":"\n

Key takeaways<\/h2>\n\n\n\n

Inflation<\/h3>\n\n\n\n

The disinflation process has begun.<\/p>\n\n\n\n

Interest rates<\/h3>\n\n\n\n

Lower bond yields will likely follow.<\/p>\n\n\n\n

Stocks<\/h3>\n\n\n\n

Rate-sensitive, early-cycle stocks may benefit.<\/p>\n\n\n\n

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\u2019re on the leading edge of a stock market recovery \u2014 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\u2019s start there.<\/p>\n\n\n\n

As an equity strategist, I care about the direction of interest rates \u2014 especially the 10-year US Treasury bond yield \u2014 because they\u2019re 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\u2019 expected cash flows. As we\u2019ve seen since October of the same year, however, that process can also work in reverse (i.e., lower bond yields and higher share prices).<\/p>\n\n\n\n

Are bond yields heading higher or lower?<\/h2>\n\n\n\n

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.<\/p>\n\n\n\n

Anyone on a fixed income over the past few years understands how accelerating prices for basic necessities \u2014 food, rent, medical care, energy, cars, etc. \u2014 sap their ability to spend on other more discretionary items. Contrastingly, decelerating prices boost consumers\u2019 ability to spend on discretionary things.<\/p>\n\n\n\n

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).<\/p>\n\n\n\n

Figure 1. Peak inflation points to lower bond yields for now<\/h3>\n\n\n\n
\"US<\/figure>\n\n\n\n

What\u2019s the outlook for US inflation?<\/h2>\n\n\n\n

In a February 7, 2023, speech, Federal Reserve (Fed) Chairman Jerome Powell said, \u201cThe disinflationary process, the process of getting inflation down, has begun\u2026,\u201d1<\/a><\/sup> an official statement that ratifies my favorable views on the general level of prices and bond yields.<\/p>\n\n\n\n

In fact, the symmetrical roundtrip of the Institute for Supply Management (ISM) Manufacturing Prices Index \u2014 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<\/a><\/sup> \u2014 suggests a strong whiff of outright deflation in the goods sector. <\/p>\n\n\n\n

Powell added that in the non-housing sector, \u201cServices [are] not really showing any disinflation yet.\u201d1<\/a><\/sup> 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 \u201cimmaculate\u201d disinflation scenario<\/a> I first wrote about in May 2022 is playing out.<\/p>\n\n\n\n

Powell also mentioned that taming inflation \u201cwill be a process that takes a significant period of time.\u201d 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.<\/p>\n\n\n\n

How do disinflation and lower bond yields affect consumer cyclical stocks?<\/h2>\n\n\n\n

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.<\/p>\n\n\n\n

When interest rates fall, however, debt-fueled consumption becomes more manageable, thereby improving households\u2019 financial outlook.<\/p>\n\n\n\n

If I\u2019m 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).<\/p>\n\n\n\n

Figure 2. Declining bond yields have supported rate-sensitive, early-cycle stocks<\/h3>\n\n\n\n
\"10-year<\/figure>\n\n\n\n

After a period of normalization and recovery, I\u2019d expect inflation and bond yields to eventually drift higher once again on the back of an expanding economy.<\/p>\n\n\n\n

If what\u2019s 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\u2019s a story for another day.<\/p>\n\n\n\n

Footnotes<\/strong><\/p>\n\n\n\n