The Big Picture
Column Summary:
*Rising U.S. debt and deficits are pushing Treasury yields higher, raising investor concerns.
*Higher yields challenge stock valuations and make borrowing costlier for companies and consumers.
*Stronger earnings growth is needed to justify current stock valuations amid rising rates.
We have stressed often that earnings trends drive the stock market. When earnings are trending higher, the stock market tends to follow. When earnings are trending lower, the stock market may not follow that trend in direct lockstep, but it often gets locked on valuation concerns that interrupt its upward momentum and invite lower prices.
There may just be a new sheriff in town, though, dictating where the stock market goes. That would be the Treasury market.
Feeling Uncomfortable
U.S. Treasuries are deemed to be risk-free securities since they are backed by the full faith and credit of the United States of America, which is the steward of the world's reserve currency. There have been some rumbles recently, however, about how risk-free U.S. Treasuries really are.
Moody's downgraded the U.S. credit rating to Aa from Aaa, citing concerns about the increase in government debt and interest payment ratios hitting levels that are significantly higher than similarly rated sovereigns. It should be noted that the Moody's downgrade came years after Standard & Poor's and Fitch Ratings also cut their triple-A ratings for the U.S. In other words, the Moody's downgrade wasn't so much a shock in terms of its review of the U.S. fiscal situation as it was in terms of its timing.
It came in the midst of the House negotiating a reconciliation bill that some forecasting firms suggested could add as much as $5 trillion to the government's budget deficit over the next 10 years. The House ultimately passed the reconciliation bill in a 215-214 party-line vote, sending it over to the Senate for consideration. The Congressional Budget Office said that, before accounting for interactions, the House's version would add $2.3 trillion to deficits over the next decade and estimates it would add $3.1 trillion to the debt as it is written.
Buyers of Treasuries haven't felt entirely comfortable with such forecasts and have started to demand a higher term premium -- nothing exorbitant, mind you, but higher as they recognize more of the government's budget will need to be allocated to paying the interest on the U.S. debt, which currently stands at $36.9 trillion, or 123% of nominal GDP.
Time Will Tell
The 10-yr note yield, which stood at 4.00% in early April, recently went as high as 4.63%. It currently stands at 4.50%, which is actually seven basis points less than when the year began.
That is an important distinction when it comes to tempering just how fearful the market has been about the budget negotiations, but the trend matters, and there is a nervous tension in the market that it is going to continue higher since it isn't at all clear that the U.S. government's fiscal trajectory will improve soon.
The counterargument is that the tax-friendly provisions of the reconciliation bill will ignite increased growth that makes up the deficit gap with increased tax revenues resulting from the stronger growth.
Only time will tell if that is the case, but rest assured the Treasury market will be keeping time, and the stock market is going to know if it is time for the U.S. government to make a more concerted effort to get its spending under control.
How will it know? Treasury yields will head higher in an unhinged fashion with so-called "bond vigilantes" selling their positions and/or balking at buying new supply that lacks, in their judgment, an adequate term premium.
Briefing.com Analyst Insight
This is a situation that could play out slowly over time or happen suddenly. With moves in Treasury yields, it isn't always the level that stirs the stock market, as it is the pace of change. To that end, 4.50% is not a "high" yield, but considering it is up 50 basis points since early April, it has caused a stir that has slowed the stock market's recovery momentum. In the same vein, the 30-yr bond yield of 5.03% is not "high" either, but it is also up 60 basis points since early April.
Source: FactSet
The stir is that these yields for risk-free securities are creating increased competition for stocks, which are not risk-free, and which have pushed the market cap-weighted S&P 500's valuation back to a lofty 21.2x forward twelve-month earnings. That is a 16% premium to the 10-year average, according to FactSet -- a premium that will demand stronger earnings growth to sustain.
Source: FactSet
That will be an increasingly challenging proposition if rates continue to rise, making it more expensive for companies to finance their debt and more onerous for consumers to take on new debt and/or to service existing debt with a variable rate structure. In the end, this all gets back to earnings driving the stock market.
Interest rates matter, and they are at risk of rising further if inflation rates start to accelerate due to the tariff actions and/or changes to the reconciliation bill by the Senate increase deficit forecasts.
That could be a problem for the stock market and the U.S. government, particularly if the Treasury market thinks it is a problem.
