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Another round of interest-rate adjustments struck financial markets on Wednesday, putting equities further at risk of missing out on a sustainable return to an early 2023 rally.
As the policy-sensitive 2-year Treasury yield inched closer to 5% and the benchmark 10-year rate briefly pierced 4%, investors and traders sold off the broader S&P 500 and Nasdaq Composite in tandem with bonds, underscoring just how wobbly risk assets could remain for the rest of 2023.
Meanwhile, the 1-year T-bill rate
TMUBMUSD01Y,
moved further above 5%, making cash and cash-like instruments more appealing than either stocks or bonds for many investors, said Jack McIntyre, a portfolio manager at Brandywine Global Investment Management in Philadelphia.
Hopes for a quick end to the Federal Reserve’s rate-hike campaign have faded with each passing week since early February. Wednesday’s data on the expansion of China’s manufacturing activity and a surprising acceleration in German inflation — plus tough talk from policy makers on the need for higher rates — only added to the diminishing chances for a pivot in the U.S. central bank’s policy soon.
As a result, traders slightly nudged up the likelihood of a half-of-a-percentage-point rate hike this month, and boosted their expectations for where rates are likely to end up by September: which is at least 5.5% to 5.75%, or possibly higher.
“In plain vanilla terms, the higher rates go, the increasing odds we go into a recession and that’s what is going to derail equities,” said McIntyre of Brandywine Global, which oversaw $53 billion as of December. “If inflation stays stickier, that further increases the odds.”
“We’re not quite on board with saying that it will be a bad year for equities,” he said via phone. “But we are going to be just a little more on edge, given the lag effects of all the Fed’s tightening, which could impact the economy later this year, and lead to slowing growth. We are riding out this backup in yields by being long Treasurys and owning double-digit emerging-market bonds.”
The bond market has regularly set the tone for risk assets, as Treasury yields move higher in conjunction with the most likely path for interest rates.
On Wednesday, the 2-year rate
TMUBMUSD02Y,
rose further into its highest levels since 2007, while the 10-year rate
TMUBMUSD10Y,
moved to the edge of 4%. The last time the 10-year rate has ended the New York session above 4% was in November, but it hasn’t remained sustainably at that level in more than a decade.
Meanwhile, rising rate expectations left the Treasury curve headed for its deepest inversion since Oct. 2, 1981. The spread between 2- and 10-year Treasury yields briefly inverted to minus 97.7 basis points before settling around minus 89 basis points in the afternoon. That inversion is traditionally seen as a reliable indicator of an impending recession.
U.S. stocks
DJIA,
COMP,
were mostly lower Wednesday afternoon, a day after closing out a tough February with losses that left Dow industrials with a 4.2% monthly drop, the sharpest decline since September. By contrast, January’s monster rally left the S&P 500 with a solid 6.2% monthly gain and the Nasdaq Composite with an even better 10.7% showing.
Read: Why March could ‘make or break’ stock-market sentiment with 2023 rally at crossroads
“There has been a dramatic repricing in the forward interest-rate curve, led by the front end and it’s not surprising to me that hopes for an end to the Fed’s tightening cycle have faded,” said Mark Heppenstall, president and chief investment officer of Penn Mutual Asset Management in Horsham, Pennsylvania, which oversaw more than $31 billion in assets as of January.
“Uncertainty around the end of rate hikes makes it difficult for risk assets to rally from here,” he said via phone. “Expectations had been that inflation had turned a corner. Then all of a sudden people just questioned that disinflation trend. The biggest question now is, ‘Where do you think rates will peak out?’ “
Heppenstall said he sees a chance that the 10-year yield will get to 4.5% this year and thinks equities will be moving in uneven spurts in either direction for the rest of 2023.
“It’s possible that both bulls and bears are going to be disappointed this year. Until there’s clarity on interest rates, there’s going to be fits and starts in risk assets, although the tail risk of a downside is increasing as the Fed extends its tightening cycle,” he said. “I see a bigger risk in an economic slowdown in the second half of the year.”
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