Rising interest rates are a challenge for the bull case. Rates are rising, not because real growth is picking up, but because inflation is forcing central banks to rethink policy. As Chart A (below) shows, different yields across markets are making new highs. These increases are forcing a rethink of valuations and adding to volatility.

Since the start of the year:

  • 3-Month Treasury Bill Yields are up to 0.9% from 0.0%;
  • 10-Year Treasury Bond Yields doubled to 3% from 1.5%;
  • 30-Year mortgages rose to early 5.5% from 3.25%;
  • Baa Corporate Bond Yields are now 5.2% from 3.3%;
  • The S&P 500 earnings yield (12-month forecast earnings divided by price) is up to 5.7% from 4.7%.
Bond Market Surprised

These increases came as a surprise — even “sleepy” bonds like 5-year U.S. Treasury bonds lost 7% from January through April. This four-month decline ranks among the most considerable historical losses for the instrument. Even bond investors holding highly conservative, intermediate-term Treasuries experienced unusual pain. At the long end of the Treasury spectrum, holders of zero-coupon 30-year U.S. Treasury bonds lost about 25%.

The good news, of course, is that rising rates mean savers will be able to reinvest cash from coupons and maturing bonds at more attractive rates. The positive impact on wealth from higher reinvestment rates can be significant, especially for investors with a long horizon.

Chart A
Yields Rise Across Markets
More Costly to Borrow

Of course, not everyone benefits from higher rates. Consider a person borrowing for a home purchase. A $275,000 mortgage cost $1,088 per month at 3.25% back in January. Today’s same mortgage costs $1,419 now that the average 30-year U.S. mortgage stands at 5.5%. That extra $419 per month comes when the average home price is up 35%, based on the S&P Case/Shiller National Home Price Index.

A similar rise can be seen for corporate borrowers. The average yield on a Baa issuer is now 5.2% versus 3.3% in January. Still, the increase was primarily due to a jump in Treasury yields, so there is no real sign markets are all that worried about corporate defaults. The “spread” or difference between Baa corporate bonds and a 10-year U.S. Treasury bond increased slightly. That spread increased to 2.2% today from 1.80% in January. Over the past five years, the spread ranged between 1.75% and 2.75%, leaving today’s 2.2% near the center of the range.

It should also be pointed out that earnings forecasts for the S&P 500 are still climbing, despite recent worries. Today, analysts expect $237 of operating earnings from the S&P 500 companies, a record that stands 33% above pre-pandemic levels. Moreover, the “earnings yield” is now 5.75%, roughly 2.6% above the 10-year U.S. Treasury yield. As you can see in Chart B (below), this is near the low end of the 5-year range and suggests room for a further move higher. Such a move could happen due to falling bond yields, rising earnings, falling stock prices, or a mix of all four factors.

Chart B
S&P 500 Earnings Yield Minus 10-Year U.S. Treasury Yield

As we wrote at the start of the year, and in our Q2 Tactical Asset Allocation quarterly, we believe a shorter duration posture makes sense. In our view, the ramp-up of inflation and response by central banks to contain it accelerated a much-needed adjustment to bond pricing. Beyond bonds, incoming data presents a mixed bag, especially compared with months ago. Chart C below shows the forecast path for the WCA “Barometer,” (chart, below) which measures a variety of market-based and other inputs to our outlook. As you can see, the expected short-term path for the barometer is near 40, indicating some weakness.

Consequently, we reduced equity exposure at the start of the month to below neutral in the satellite portions of tactically-allocated portfolios (40% equity currently versus 50% last month and 70% a year ago). We will continue to monitor incoming data, update our forecasts at the start of each month, and make appropriate adjustments as warranted.

Chart C
WCA “Barometer”

Kevin R. Caron, CFA
Senior Portfolio Manager

Chad Morganlander
Senior Portfolio Manager

Matthew Battipaglia
Portfolio Manager

Steve Lerit, CFA
Senior Risk Manager

Paul Clark, CFA
Senior Portfolio Manager
Municipal Fixed Income

Rick Marrone
Senior Portfolio Manager
Municipal Fixed Income

Daniel Urbanowicz
Senior Portfolio Manager
Municipal Fixed Income

Suzanne Ashley
Internal Relationship Manager

Eric Needham
Director, External Sales and Marketing

Jeffrey Battipaglia
External Sales and Marketing

WCA Fundamental Conditions Barometer:

We regularly assess changes in fundamental conditions to help guide near-term asset allocation decisions. The analysis incorporates approximately 30 forward-looking indicators in categories ranging from Credit and Capital Markets to U.S. Economic Conditions and Foreign Conditions. From each category of data, we create three diffusion-style sub-indices that measure the trends in the underlying data. Sustained improvement that is spread across a wide variety of observations will produce index readings above 50 (potentially favoring stocks), while readings below 50 would indicate potential deterioration (potentially favoring bonds). The WCA Fundamental Conditions Index combines the three underlying categories into a single summary measure. This measure can be thought of as a “barometer” for changes in fundamental conditions.


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