Santoli: The Current Frenzy Over Bond Yields Explained

The American economy is experiencing a heated summer, with the bond market acting as a critical thermostat, raising borrowing costs to multi-year highs as demand for debt from governments and corporations intensifies. This surge in bond yields, while currently not significantly curbing capital raising or corporate investment, particularly in the AI sector's massive computing capacity buildout, poses a risk of cooling down other economic areas like housing and consumer spending.

This situation has led Treasury Secretary Scott Bessent to explore measures to temper longer-term Treasury yields, such as expanding a program to repurchase less liquid government debt. This initiative sparked considerable debate among market participants and commentators, with criticisms ranging from its appearance to its potential ineffectiveness. The subsequent reversal of initial yield drops, alongside a weakening U.S. dollar and rising gold prices, further fueled concerns about the financial policy management.

The bond selloff has also reignited anxieties about the nation's fiscal sustainability. Concerns over the U.S.'s ability to finance its structural deficits tend to flare up under market stress, similar to an autoimmune response, before subsiding.

However, the recent rise in the 10-year Treasury yield to 4.74% is a modest increase, and this level has been seen before in the past three years. Investment-grade corporate debt yields remain below their previous peaks due to tight spreads over Treasuries. For major corporations, current yield levels are not yet broadly prohibitive, nor are they significantly dragging down equity values. Given the current nominal GDP growth of around 5-6%, the current 10-year yield is not unusually high, and the yield curve's steepness is also within historical norms.

So, what's driving all this commotion?

The relative orderliness of the market movements so far has allowed the stock market to remain resilient. There aren't clear yield thresholds that immediately harm equities, though investors are watching closely. Conventional economic theory suggests that a peak in real yields—currently exceeding 3%—should curb economic growth and equity valuations. However, these effects can be gradual and offset by strong corporate growth.

The S&P 500 has largely benefited from the AI boom, with approximately one-third of its recent earnings growth attributable to AI infrastructure companies. This makes the S&P 500 more of a benchmark for capital goods and business-to-business activity than a broad measure of U.S. consumption. Consumer discretionary stocks, for instance, represent a small portion of the index, especially when excluding major tech companies like Amazon and Tesla.

Consequently, the market remains close to record highs, even as indicators like July housing starts have declined and Walmart has reported its weakest comparable-store sales growth since 2020. This doesn't imply a widespread economic downturn; consumer spending remains stable, unemployment is low, and the overall consumer debt burden is manageable.

However, with wage growth slowing while inflation persists, and with tax refunds no longer providing a boost, the economy's momentum is primarily driven by corporate spending fueled by robust earnings. This capital-over-labor dynamic means rising interest rates are perceived by the public as a negative for affordability rather than a sign of economic strength.

A Countertrend Rally in Bonds?

For investors, the increase in real yields on Treasuries, which raises the cost of borrowing, also represents compensation for bondholders. This raises the question of whether value is emerging in bonds, even as conventional wisdom doubts their diversification role for equities.

Barry Knapp of Ironsides Macroeconomics observes that the recent rise in yields has occurred despite softer inflation and employment data, as well as mixed consumer indicators. He suggests that "Although we continue to be secular bond bears, and do not view the Treasury Secretary's actions as a significant positive catalyst, we still think there is scope for a countertrend rally in long maturity [Treasuries]."

The S&P 500 saw a slight decline of 1.4% last week as bond market discussions dominated. Equity investors are monitoring how higher yields affect capital allocation in both public and private sectors. The very factors driving the AI surge—strong consumption and capital deployment—are now contributing to rising rates and potentially restraining growth elsewhere.

Semiconductor stocks dropped over 5%, facing resistance, while other sectors also saw declines. Banks fell 4%, and industrials, often seen as indirect beneficiaries of AI, lost over 3%. The S&P 500 itself retreated towards the upper end of its previous range before a modest bounce.

Rick Bensignor, a strategist at Bensignor Investment Strategies, believes that technology stocks may have peaked in relative terms, with healthcare and financials showing more promise. He notes technical warning signs in the S&P 500's recent performance, suggesting potential institutional selling. Bensignor cautions that without new catalysts from companies like Nvidia, the market may need to adopt a more cautious stance.

Market Temperature Gauge

This indicator, developed by John Kolovos of Macro Risk Advisors, synthesizes investor sentiment and actions. Kolovos notes that an increase in bullish sentiment contributed to the recent stock market pullback. He remains concerned about low implied volatility levels, despite a generally bullish outlook for the market, and recommends tactical VIX call spreads as a hedge.

Around the Street

The enduring relevance of "The Money Game," published in 1968, is highlighted by its depiction of a previous technology boom, reminiscent of today's AI-driven market. An anecdote from the book about "computer leasing stocks" illustrates the speculative fervor surrounding new technologies and their financing models, drawing parallels to current practices where hardware manufacturers facilitate customer tech purchases.

The Wall Street Journal features an engaging obituary for Victor Niederhoffer, a notable and colorful trader who passed away recently. Niederhoffer, known for his bold trading strategies, experienced significant successes and failures, including substantial losses from shorting volatility before market downturns.

Market on Close

The recent strong earnings growth relative to stock price increases has led to a perception of valuation compression through easier means. While the price-to-earnings ratio has decreased, the significant reinvestment by top-earning companies for AI buildouts has led to a scarcity of free cash flow. The S&P 500's price-to-free-cash-flow ratio, based on projected figures, is currently at a multi-decade high, just under 30. This indicates a free cash flow yield of 3.4% for stocks compared to the 10-year Treasury yield of 4.74%.

The substantial corporate cash burn is largely a deliberate strategy, with major tech firms investing heavily in the AI race and data center capacity. This aggressive investment aims to secure a competitive edge in the development of advanced artificial intelligence.