| U.S. equities are lower, and Treasuries are fluctuating as Federal Reserve Chair Jay Powell testifies in front of Congress today and tomorrow. Powell has reiterated his commitment to keeping interest rates low and to continue with asset purchases, as the labor market and inflation remain far from target levels. |
But this is the easy part. The more interesting element is whether or not Powell will express concern over rising yields. To this point, interest rates around the world continue to move higher. Thus far, the story has been one of optimism: strong growth with rising, but not troublesome, inflation. This narrative has worked so far, but it is a difficult balance. If rates rise too quickly, that can actually delay the recovery. There are two primary channels through which this could happen. The first is that higher yields could hit interest rate–sensitive sectors of the economy, such as housing. The second channel would be through an equity market sell-off or tightening of available credit that could lead to a negative confidence shock.
The housing market has been a bright spot for the economy, with new home sales up 18.7% last year and existing home sales up 6.5% despite the economy being in lockdown since last spring. As of January data, building permits have reached their highest levels since 2006. Historically low rates and a reallocation of cash toward housing as a result of the pandemic have been key drivers. But both of these factors could swing the other way as rates continue to rise and consumers reallocate money back toward leisure and services spending. As such, it is possible we see a pullback in housing activity during the second half of 2021, which would have a dampening effect on the economy.
Rising rates also pose a risk to credit and equity markets. While there is a range of estimates, analysts appear to be looking at 10-year yields at or just under 2% as the range in which equity markets could start to come under stress. Of course the reason behind the rise in yields is also important, with a rise in rates driven by rising real rates being more problematic than a move led by inflation breakevens.
Another factor to keep an eye on is the notion of “there is no other alternative.” Previously, this has been used as a bullish argument for equity markets, as the majority of S&P 500 stocks pay a dividend yield higher than the 10-year yield. But higher yields make this a less compelling argument. That said, rising rates alone are not bad for stocks, as equities have risen during 13 of the last 15 rising-rate cycles.
Nevertheless, an equity sell-off can impact the economy by dampening confidence. Rising rates can also negatively impact the economy through the reduced availability of capital to corporates, with the pace at which rates move being a critical element due to the destabilizing effect of sharp moves, especially if this move higher is led by real rates. Conversely, a measured rise that reflects improving economic fundamentals will be absorbed much easier and be more acceptable for risk assets. The takeaway is that there are checks and balances between the markets and the economy. Furthermore, the components that make up growth and the rate of rate of growth are important factors in determining how sustainable the recovery can be.
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