In recent days, U.S. stocks have found an unexpected ally in a historic drop in bond yields. U.S. government bond yields experienced a steep decline this week, with some durations marking their largest drops in decades. This comes as investors predict the Federal Reserve will likely curb its aggressive rate hike trajectory to prevent further financial system stress following Silicon Valley Bank's and Signature Bank's failures (NASDAQ: SBNY).
Equities Benefit from Falling Yields
The volatility in fixed-income markets has unsettled investors, and falling yields can indicate expectations that the Fed will cut rates due to a hit to growth. However, the yield drop has been a boon for equities, particularly tech and other large-growth stocks. These stocks have performed well and supported the benchmark S&P 500, which finished up 1.4% weekly.
Fed Meeting to Influence Yield Trajectory
The near-term trajectory of yields will likely depend on the upcoming Federal Reserve meeting. If the central bank signals to prioritize financial stability and slow or pause its rate increases, yields may fall even further. However, yields could rebound if the Fed prioritizes fighting inflation, which remains high despite numerous rate increases.
Market Uncertainty Surrounds Fed's Approach
Investors are currently still determining how the Fed will address the situation. Futures markets show a 60% probability of a 25 basis point rate increase at the Fed's March 21-22 meeting, with rate cuts to follow later in the year. This is a significant turnaround from the hawkish expectations that prevailed earlier in the month.
Balancing Inflation and Financial Stability
Michael Arone, a chief investment strategist at State Street (NYSE: STT) Global Advisors, said that the Fed must now balance its inflation-fighting credibility with financial market stability for the first time during its tightening cycle.
Stocks Regain Appeal Amid Rate Drops
According to some metrics, the recent decline in rates has helped stocks regain their allure. The equity risk premium has rebounded to where it stood in early January but remained near its lowest level in over a decade. However, other metrics show that stocks remain expensive by historical standards.
Recession Fears Drive Tech Stock Rally
The rally in interest-rate-sensitive sectors like tech stocks indicates that the market expects rates to continue falling as a widely feared recession approaches. The S&P 500 information technology and communication services sectors rose 5% and nearly 7% for the week, driven by strong gains in Microsoft Corp (NASDAQ: MSFT) and Google parent Alphabet (NASDAQ: GOOGL) Inc.
Investor Skepticism of Stock Valuations
Some investors are skeptical of stock valuations. Bob Kalman, senior portfolio manager at Miramar Capital, argues that the Nasdaq 100 should trade at no more than 25 times forward earnings, given current interest rates, below its current 27.3. He believes the Fed must prioritize fighting inflation over the concerns caused by a few bank failures.
