The bear steepening of the yield curve could force the Fed to continue hiking.Based on relative yields, comparing the earnings yield and the nominal bond yield, the demand for stocks falls as investors shift their investments from stocks to safer and higher-yielding Treasury Bonds.Higher yields tend to reduce the valuation metrics, for example, PE ratios, which is particularly important given the currently elevated valuations with the forward PE ratio for S&P 500 at 21.As interest rates increase, the present value of future cash flows decreases, which reduces the intrinsic value.Higher long-term yields have a negative effect on the stock market for several reasons. Thus, the cross over the 4% yield red line potentially signals the march towards the 5% yield level on 10Y Treasuries. Fitch just downgraded US Debt due to unsustainable spending and ineffective governance, which potentially adds some risk premium to the nominal yields.Īll of these variables potently increase the market supply of US Treasuries, at a time when the demand is vanishing.The US government is set to significantly increase the supply of US Treasury Bonds to finance President Biden's programs and cover the rising budget deficit.Furthermore, President Biden's push to increase manufacturing spending is boosting the US economy at a time where such "boost" is actually a negative as it pushes inflation higher, and works against the Fed's efforts to cool off the demand. US inflation is likely set to increase again (as the base effects expire) induced by the higher wages, the spikes in commodity prices, and the general pressures caused by the unfolding de-globalization.The Fed is expected to reduce balance sheet until 2025. The QT is designed to increase real interest rates. The Fed is still implementing the quantitative tightening QT, or the reduction of balance sheet, which also increases the market supply of Treasury Bonds, and reduces demand.Japan is the biggest holder of US Treasury Bonds, so this is a significant variable for future demand for US Treasuries, and the current market supply. The Bank of Japan has started to exit the extraordinary monetary policy easing, and the decision to allow the 10Y JGB yield to reach the 1% level is likely to cause higher long-term interest rates in the US as Japanese investors sell US Treasuries to buy domestic bonds.Specifically, the current macro environment favors an increase in long-term interest rates for the following reasons: In fact, the summer rally peaked as the yield on 10Y Treasuries decisively crossed the 4% level. However, it seems like currently, the stock market sees the 4% yield on 10Y Treasury Bonds as the red line. The stock market can digest a certain level of long-term interest rates, and also a certain level of short-term interest rates. The increase in inflationary expectations requires the Fed to further increase the short-term interest rates. This is a situation where long-term rates increase faster than short-term interest rates, due to an increase in long-term inflationary expectations, real interest rates, or both. ![]() Specifically, further economic strength would likely cause an increase in long-term interest rates, or a bear steepening of the yield curve. The summer rally, which some call a new "bull market", is fading and the cyclical bear market is set to resume.
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