Interest Rates and Equity Risk

The benchmark 10-year US Treasury yield slid to 2.2 per cent this morning, its lowest level since October 2017. The move reflects investor skittishness in an environment of trade battle uncertainties, business leader reticence and caution emanating from the Federal Reserve. Declining Treasury yields are a harbinger of rising risk. The yield differential between the 10-year note and the 3-month bill, a barometer of economic prospects, slipped into negative territory over the last few days as future growth concerns have heightened.

The recent rate moves have rattled stock investors. Blue chips have lost ground for what’s shaping up to be four consecutive weeks, as growth concerns migrated to the equity markets. The S&P 500 is off about 5 per cent from its most recent high but remains 12 per cent higher for the year. Yield spreads, the premium demanded by lenders to extend credit to lower-quality borrowers, have widened also. The yield differential between a 10-year BBB note and a similar-maturity Treasury is 2.3 per cent, up from 2.1 per cent two weeks ago. Though this trend reflects heightened credit risk, we underscore that credit conditions remain sanguine by historical standards.

The recent rate slide has not been kind to equities. On a sectoral view, over the last 50 weeks 10 of the 11 S&P 500 sectors have lost ground during the 16 weeks when the 10-year Treasury yield declined by more than .05 per cent. Economically sensitive sectors, like industrials, financials, energy and materials, have borne most of the brunt. Yield-oriented sectors, like utilities, REITs, telecom and consumer staples, have been relatively insulated. While we do not believe we’re facing an imminent recession, we sense there’s an additional 5 per cent downside risk to the markets as investors adjust to a lower growth trajectory.