Higher long-term interest rates sent Wall Street lower on Tuesday morning, following a long weekend.
At 9 a.m., the S&P 500 futures were trading 0.92% lower, the Dow Jones futures 0.73%, and the tech-heavy Nasdaq 1.48%
The benchmark 10-year U.S. Treasury bond has climbed from around 1.5% in late November to about 1.8% this week. Meanwhile, the 30-year U.S. Treasury bond is trading at approximately 2.1% this week. Both rates are the highest they have been in the last two years.
Long-term interest rates are driven higher by the return of inflation, which is running close to 7%. That’s a 30-year high and more than three times higher than the Fed’s official target. Inflation undermines the value of fixed income securities like bonds, as investors demand a premium for the loss of the purchasing power of their money.
That explains why bonds have been bad investments in inflationary periods like the 1970s and the 1980s, when bond markets crashed, sending yields to double-digits.
Tapering
Then there’s tapering, the rolling back of the Fed’s bond and buying program of mortgage-backed securities (MBS). It officially kicks off this week and is expected to end in March of 2022. The purpose of this policy is to restrain spending across the economy to bring inflation under control.
Tapering means that a big buyer of government bonds will no longer be there to buy the debt issued by the Treasury Department. That’s why tapering means lower bond prices and higher yields.
Higher bond yields slow down both consumer and business spending, which hits the top line of listed companies. They raise borrowing costs, which hits the bottom line of the capital-intensive companies. They also depress future equity valuations, as U.S. government bond yields are a crucial input to the Discounted Cash Flow model to calculate the intrinsic value of listed companies.
Aiding Wall Street’s jitters on Monday morning were a couple of more things. One is a disappointing earnings report from Goldman Sachs due to rising expenses.
Goldman Sachs’ earnings disappointment comes a few days after JP Morgan mentioned higher costs as a headwind for its earnings. Both reports helped cool off the financial sector, accounting for a big chunk of the S&P500.
Then there was news from China over the long weekend that its recovery was stalling. Chinese consumers have been scaling back spending due to lockdown measures to fight the Omicron variant of COVID-19, which forced the country’s central bank to cut interest rates.
In addition, the lockdown actions raise fears that these measures will add to the global supply woes, which are often cited as the primary source of worldwide inflationary pressures.
Bottom Line
The world economy may be in for a vicious cycle of inflation-interest rate spikes, which could force traders and investors to re-think valuations, meaning that Wall Street volatility is here to stay.
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