Drop in 10-Year Treasury Yield Baffles Market Strategists

"If you know what the 10-year Treasury is doing, you can predict all other markets," says Brian Nick, chief investment strategist at Nuveen.

Ten-year Treasury yields are key for currency rates and in the stock market, the driving force behind which sectors will outperform and which won't, according to Nick.

In the first quarter, when 10-year Treasury yields were rising, financials and energy stocks outperformed, reflecting higher inflation and inflation expectations as the economy accelerated. "It was off to the races," said Nick.

By the second quarter, 10-year Treasury yields were falling, as concerns about a slowing economy and resurgence in COVID-19 infections due to the more contagious Delta variant grew. The so-called reflation trade retreated and tech stocks, REITs and health care securities outperformed.

The 10-year Treasury yield, which almost doubled in the first quarter from 0.92% to 1.74%, retreated to 1.25% in intraday trading on July 8 and 1.29% on the close. It has since rebounded to trade between 1.35% and 1.41%.

The Inflation Debate

What happens next to the 10-year Treasury yield and to U.S. stocks is uncertain not just because no one can be sure of the future but also because the decline in long-term rates doesn't seem to fit an economy that continues to gather momentum.

"From a longer term perspective there is a big debate going on about inflation right now," says Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research. "One camp says the Fed is being too lenient and is running the risk of letting inflation get too high which will result in the Fed having to slam on the brakes at some point."

"On the other side are those that say the long-term factors holding inflation such as demographics of an aging population, declining trend in workforce, globalization, heavy debt levels, etc., mean that the overall trend is lower even if this is a temporary rebound in inflation," Jones adds.

There are those like Bank of America Securities strategists who write in the latest research investment committee report (RIC) the "too-hot inflation" in Q2 and the "too-cold GDP" in Q3 that investors fear is creating "just-right conditions for equities & credit."

What Long-Term Treasury Yields Are Signaling

Long-term Treasury yields are unusually puzzling this year. "How can it be in a quarter that grew by almost 10% annualized and had a stronger year-over-year core inflation number that long-term rates fell by close to 50 basis points from peak to trough?" asks David Kelly, chief global strategist at JPMorgan Asset Management.

"There is a little bit of deceleration but the economy is barreling along to full employment. Inflation may edge down a bit, but it's way above what the Fed wants to achieve in the long run," Kelly explains.

The personal consumption expenditures deflator excluding food and energy — the Fed's preferred inflation indicator — rose 3.4% in May from one year ago. Consumer prices excluding food and energy jumped 4.5% over the last 12 months — the biggest 12-month increase in almost 30 years.

Bob Doll, chief investment officer of Crossmark Global Investments, expects the underlying inflation rate and wage growth will likely "prove sticky" and bond yields will resume their climb, but he remains "modestly" positive on stocks given a "still quite robust" economy.

Nuveen's Nick agrees. "Equities will outperform fixed income and cash throughout this year and next year," although the "equity risk premium in the U.S. is probably more modest than it was," he says. He expects the long-term bond yields will "crawl up" slowly.

Carl Weinberg, the founder and chief economist of High Frequency Economics, and David Rosenberg, the president and chief economist and strategist at Rosenberg Research & Associates, disagree.

They don't expect long-term rates to rise because the economy is slowing; price data increases reflect only a limited number of sectors such as cars, housing and travel; and prices of commodities like lumber and copper are already falling. All these indicators point to a continuation of current Federal Reserve policy to support the economy, not preparation to taper asset purchases.

Weinberg even sees prices "falling outright," rather than increasing more slowly.

Lower bond yields are "telling you that economy and earnings expectations are probably too high," said Rosenberg. But he isn't forecasting a big drop in the S&P 500 where only half the stocks have been making new highs.

"If growth is slowing and the yield curve is flattening, you don't want to be in financials or value stocks. You want to tilt toward growth," said Rosenberg noting that tech, health care and more recently telecom have been propelling the large-cap index higher.