It’s fairly normal for stock investors to ignore the bond market. After all, stock investors tend to stay in the fast lane, embracing risk in search of 8% to 15% annual returns. So there isn’t much reason for stock investors to glance over at the Treasury bond market, where timid investors pick up about 3% interest per year as they putt-putt along in the slow lane.
Recently, when stock investors noticed that the rising 10-year Treasury yield kept landing in news headlines, the U.S. stock market stopped advancing, and then stocks gave back all their gains from the last three months. Now you’re wondering, “Who are these bond people, why are they upset about a paltry 3.2% bond yield, and why is their hand-wringing affecting the stock market? Is something bad happening? Will it hurt my stocks, or am I staring at a buying opportunity?”
It helps to understand a few bond basics.
How Bonds Work
First, I’m just going to talk about really safe bonds: U.S. Treasuries. (A discussion about riskier bonds isn’t really necessary right now.) Treasury bonds have two moving parts: the price and the yield. Presumably, an investor can buy a $10,000 U.S. Treasury bond and lock in an interest rate of 3.2%. (We’re using 3.2% as an example. However, the interest rate can change throughout the day.) Once you buy that $10,000 bond, the price changes a little bit every day, but it’s guaranteed to be worth $10,000 upon maturity. The average investor does not need to stress out over the price fluctuations. If you want a bond, but don’t want to hold it for more than three years, then you just buy a three-year bond. It’s a fairly straightforward transaction.
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So why do news pundits seem obsessed with the rising 10-year Treasury yield right now? Well, it’s a lot harder to manage bond portfolios during periods of rising interest rates than it is during periods of falling interest rates. Honestly, when rates are falling, you can throw darts at bonds and make money. But when rates are rising, bond prices fall. Yikes!
You read that right. Sure, the bonds will come due at full price upon maturity, but portfolio managers around the world are generally not buying bonds with the goal of holding them until maturity. They’re buying bonds with the goal of collecting interest and also finding ways to profit from the principal. It’s hard to navigate through bond markets during periods of rising interest rates when the natural order of things is to see bonds lose value!
Now that we see that rising interest rates can scare portfolio managers—even paltry rates like 3.2%—here’s the next question: “Why are interest rates rising?”
Interest rates rise and fall throughout the economic cycle. Their primary function is to control inflation. That’s a little bit complicated and I’m not going to get into the weeds, other than to point out that when the economy is booming – which it is right now in 2018 – the costs of goods and services tend to rise.
Rising costs are commonly referred to as inflation. In an attempt to put a lid on inflation, the Federal Reserve increases interest rates. The theory is that the more it costs businesses to borrow money for business expansion, the more likely they will think twice and thrice before borrowing money, thus reining in economic growth to a slower pace. Slower economic growth tends to lead to lower inflation numbers, thus keeping costs under control, and keeping the Federal Reserve happy.
Circle back now to October 2018, and we’re seeing U.S. stock markets fall. Are they falling because these tiny increases in the 10-year Treasury yield represent some kind of hurricane in the financial markets? Or are stocks falling for a different reason? And is that reason major or minor?
Most stock investors know that U.S. companies are doing very well in the current economy. Several factors are contributing to bigger-than-usual corporate profits, including the Tax Cuts and Jobs Act and deregulation. Companies have more money this year than they would have had without those two recent economic events. Repatriation of corporate cash also contributed to the big inflow of cash into U.S. companies.
Companies are spending this money in many areas – hiring new employees, increasing wages, and business investment – all of which lead to increased money flow throughout the economy. The economy is thriving because individual people and businesses are thriving. So there’s every reason to believe that stocks of healthy companies will also thrive.
But stocks don’t go straight up, right? Unless you began your stock-investing career two weeks ago, you know that stocks bounce around. They bounce upward during bull markets and they bounce downward during bear markets. We are currently experiencing a price correction during a bull market. Nothing horrendous has happened to U.S. companies. They’re not suddenly going bankrupt. Consumers did not cease spending money. Workers are not being fired en masse.
10-Year Treasury Yield Fear = Buying Opportunity
It’s just a normal stock market correction. We had a big correction in February, and now we’re having a smaller correction in October. And in between those two dates, the major U.S. stock market averages completely recovered from the February correction and rose to new all-time highs.
My suggestion is that patient and opportunistic investors buy stocks during this temporary market downturn. Add to positions in great companies that you already own, or consider some of the buy-rated undervalued growth stocks my in Cabot Undervalued Stocks Advisor.
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Timothy Lutts heads one of America’s most respected independent investment advisory services. Each week, Tim personally picks the single best stock in his exclusive Cabot Stock of the Week advisory. Build your wealth and reduce your risk with the top stock each week for current market conditionsLearn More