Long-term Treasury Yields Expected to Decrease, But Stocks and Corporate Bonds May Not Benefit
Treasury Rates Retreat from 16-Year High as Stocks Gain
The recent pullback of the 10-year BX:TMUBMUSD10Y and 30-year BX:TMUBMUSD30Y Treasury rates from their 16-year high, despite a rebound on Thursday, suggests that long-term Treasury yields are likely to fall by the end of the year, according to Capital Economics. On Thursday, the 10-year Treasury yield rose by 9 basis points to approximately 4.654%, while the 30-year Treasury rate gained 8.7 basis points to 4.785%, as per data.
This retreat in Treasury rates has provided support to the gains experienced by U.S. equities and corporate bonds earlier this week. In fact, the three stock indexes witnessed four consecutive winning days. The yield of the ICE BofA US Corporate Index fell by 5 basis points to 6.08% on Wednesday, based on data from the Federal Reserve Economic Data. It's important to note that bond prices and yields move in opposite directions.
Temporary Breakdown in Relationship between Treasuries, Stocks, and Corporate Bonds
Hubert de Barochez, market economist at Capital Economics, believes that the current situation is unlikely to persist. In a recent note, de Barochez stated that while Treasury yields may continue to fall, the correlation between Treasuries and corporate bonds as well as equities is expected to break down in the near-term before reasserting itself next year.
Outlook for Treasury Yields and Economy
De Barochez predicts that the 10-year Treasury yield will decline by approximately 80 basis points by the end of the year. This projection is based on the expected slowdown of growth in the U.S., potentially leading to a mild recession. Furthermore, de Barochez suspects that this economic scenario will result in a faster reduction in inflation than anticipated by most. Consequently, the Federal Reserve is likely to have sufficient motivation to cut rates sooner and by a larger margin than what is currently factored into the markets, according to de Barochez.
Market Outlook: Corporate Bonds and Stocks
The current economic conditions, along with potential declines in risk-free rates, could have contrasting effects on corporate bonds and stocks, according to market expert de Barochez.
Corporate Bonds: Wider Credit Spreads
Credit spreads, which measure the compensation investors receive on corporate bonds compared to the risk-free U.S. Treasury rate, tend to widen during uncertain markets or when economic growth slows. This widening of credit spreads reflects investor wariness towards potential defaults and the uncertainty of full repayment.
Stocks: Impact of Lower Treasury Yields
Lower Treasury yields affect stocks in two ways. Firstly, it lowers the rate at which investors discount future earnings of companies. This decrease in discount rate may be offset by pressure on valuations.
Secondly, the equity risk premium, which represents the compensation investors receive on stocks compared to the risk-free U.S. Treasury rate, is expected to rise. Consequently, the earnings yield increases while earnings per share may fall. De Barochez suggests a potential decrease in earnings expectations after recent increases.
As a result, the firm predicts the S&P 500 to end the year around 4,200, representing a 4% decrease from its current level.
Long-Term Outlook: Recovery and Artificial Intelligence
Despite near-term challenges, a recovering economy holds potential for improved corporate bond and equity prices. De Barochez particularly highlights the influence of artificial intelligence, which may contribute to this upward trend.
On Thursday, U.S. stocks exhibited mixed performance. The S&P 500 showed a slight decrease of less than 0.1%, while the Nasdaq Composite traded 0.1% higher. Furthermore, the Dow Jones Industrial Average dipped 0.2%, according to FactSet data.
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