The stock market’s recent wobbles might be a sideshow. Savvy investors are laser-focused on the bond market, where long-term Treasury yields are creeping towards levels that historically trigger turbulence in equities.
One leading economist suggested late last year that the bond market, rather than stocks, would be the key indicator during the current administration. With the US 30-year Treasury yield nearing the 5% threshold, that prediction is gaining traction.
Technically speaking, the 30-year yield has been forming a "pennant pattern" since late 2022. This chart formation typically signals a continuation of the preceding trend – in this case, upwards. A decisive break above 5% is a distinct possibility, a level closely watched by major institutional investors.
Past performance offers a cautionary tale. On four separate occasions in the last three years, when the 30-year yield approached or surpassed 5%, stocks experienced short-term declines. These dips were followed by recoveries as yields retreated, each time driven by different factors.
October 2023 saw the 30-year yield climb to 5.15% amid concerns about sustained high interest rates, heavy Treasury supply, and weak auction demand. The S&P 500 subsequently fell by roughly 6% before rebounding to new highs as inflation cooled and the Federal Reserve shifted its stance.
But why are yields climbing once more?
Rising yields reflect falling bond prices, indicating a sell-off. Critically, government bonds are not currently acting as the safe-haven asset they typically are during times of geopolitical instability.
Treasury yields can be broken down into two key components: expected inflation and the "real" yield, representing the return investors demand above inflation. While not a perfect measure, this framework provides valuable insights.
Currently, both components are on the rise. Breakeven yields are increasing due to concerns about energy prices fuelling inflation. Simultaneously, real yields are also climbing, suggesting that inflation is not the sole driver. Investors are demanding greater compensation for holding long-dated government debt.
This additional compensation is known as the term premium – the extra yield buyers require for committing capital over an extended period amidst uncertainty surrounding inflation, supply dynamics, and policy decisions.
