Rates Trying to Turn

In a fairly quiet week for the equity market, we are starting to see some interesting developments in the bond market. 10-year treasury yields are trying to break out of their seven-month trading range. In 8 days, the 10-year has moved from .7% to .84%. This move may not seem like a lot, but 10-year yields have made a string of higher lows and higher highs since early August. It has gone from roughly .50% to .84% over that time frame. Momentum looks to be building towards a breakout that could be consequential for bonds and equities alike, in our opinion. The grind higher in rates is reflective of the rising inflation expectations that equities have been signaling for some time. Bonds yields are finally catching up, but they haven’t made a clean breakout. Yields tried to move through the .90% level back in June and failed. A clean break above this level would be a pretty encouraging economic signal. 

With the low end of the yield curve anchored by the Fed and rising expectations for government spending in the months and years ahead, it is only natural that the inflation expectations would start to climb as well. We view this as a healthy signal compared to the deflationary alternative. A little bit of inflation is a good thing. Hence, the Fed is working very hard to get inflation back to 2%. If rates and inflation can trickle higher, that would likely mean the economy is getting back on track after being wiped out by Covid. Historically,  the commodity markets give clues about the direction of inflation. The relative performance of copper to gold has a strong correlation with the 10-year treasury yield. Copper has been outperforming gold handily since August. If this trend continues, we believe it is likely that rates and inflation will rise with it.

For the equity market, we would expect this to impact the cyclical sectors more positively. Materials, Industrials, Discretionary, and Tech have been doing well already, and they would have more room to run with rising rates. Financials have been a notable laggard despite the broad improvement in cyclicals. However, with the rise in rates over the last few days, their relative performance has improved. This is a sector that has not participated in the Covid rally. Despite the threat of increased regulation from a Democratic administration, there is value in the space, particularly amongst the well-capitalized. We expect a momentum surge in Financials would bring a lot of interesting opportunities to the table.

Preston May, CBE®
Research Analyst