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Lower Government Bond Yields Lead to Rotation to Rate, Yield Sensitive Stock Sectors

Plunge in mortgage rates also benefiting real estate shares.

Sectors of the stock market tied to movement in government bond yields have either benefited or lost ground since last week when the Federal Reserve spooked global stock and bond markets with forecasts of moderating U.S. economic growth and an unexpected shift toward more accommodating monetary policy.

And as yields on U.S. and other developed country debt further compress, investors are seeking out higher-yielding, dividend-paying sectors of the stock market, while punishing those sectors prone to suffer in a lower interest-rate environment, namely financials.

Since the close of market trading March 20, the yield on the 10-year U.S. Treasury note has declined from 2.61% to about 2.37% through March 27, its lowest since December 2017. Bond yields across the globe have also declined sharply, with negative-yielding debt again above $10 trillion.

The trend of lower bond yields hasn’t yet led to a full capitulation from investors. The broader market as tracked by the S&P 500 is still holding on to nearly a 12.0% price gain this year through March 27, though the index is down 0.7% since March 20 – the day of the Fed announcement.

Yet, as yields have plunged, increasing prices for government bonds, income-seeking investors looking for more yield from stocks have been putting their money to work in utilities, consumer staples and so-called dividend aristocrats, or companies with a long-term track record of sustaining and growing dividends consistently over many years.

“How to play declining rates tactically within equities? As is well known, falling yields are positive for defensive bond-like sectors and growth stocks; negative for Financials, cyclical, small caps and traditional value stocks,” Binky Chadha, Deutsche Bank’s chief strategist, said in a note Wednesday, cited in this CNBC report.1

While the S&P 500 is in the red since the Fed’s dovish U-turn, the S&P 500 Utilities Sector Index has gained 1.9%, while the S&P 500 Consumer Staples Sector Index is up 1.4%. The S&P 500 Dividend Aristocrats Index is up 0.5% during the same time period. Marginal gains, indeed, but a sign, perhaps, that yield and defensive plays have become more attractive for investors seeking to position their portfolios for slowing economic growth.

For their part, real estate operators, like Real Estate Investment Trusts (REITs), have gained 2.0% since the Fed announcement as tracked by the S&P/Citigroup U.S. REIT Index.

That sentiment hasn’t been felt, however, for bank and financial stocks. The S&P 500 Financials Sector Index, is down 2.8% since the Fed announcement, though still up 6.7% year-to-date. The KBW Nasdaq Bank Index also has slipped by 4.7% since March 20, even though it has gained 7.8% this year. The recent flattening to outright inversion in the short-end of the yield curve is a worrying sign for banks’ margins. Their lending activities tend to be less profitable when the spread between banks’ short-term borrowing costs and the longer-term rates they charge on loans compresses.

Other Factors Affecting 10-Year Note Yields

As mentioned above, the surge in negative yielding debt elsewhere across the globe has attracted investors stateside, leading to more demand for U.S. Treasury notes. This resulted in the much less common inversion in the spread between 10-year Treasury notes and 3-month T-bills that occurred last week, as opposed to the more common marker of a potential recession predictor between 10-year Treasury notes and two-year notes.

“This dynamic has probably been supported by international spillovers from non-US rates where QE [quantitative easing] and low growth and inflation expectations have supported lower 10y rates,” strategists from Goldman Sachs wrote in a note cited in this CNBC report.2 “As a result, the curve inversion signal could be less powerful for recessions than in the past since long dated yields across regions have become more correlated.”

As yields have fallen, mortgage rates (tied to movements in the 10-year note) fell in the past week by the most in 10 years, according to Freddie Mac. Interest-rate hedging from mortgage investors, servicers and mortgage REITs has also pushed 10-year notes lower. As more homeowners look to take advantage of lower mortgage rates and refinance, these market participants need to ward off a potential increase in prepayments on bonds in their portfolios, losing out on future interest payments on what had been the remaining principal.

Back in mid-November, 30-year fixed-rate mortgage rates were at nearly 4.95%, but have since fallen to 4.06% for the week ended March 28, according to Freddie Mac. That significant move has led to home builder stocks, gaining ground with the S&P Homebuilders Select Industry Index up 2.7% since March 20.

Homeowners, buyers and the overall housing industry will also benefit from lower rates. As Freddie Mac said this week in its mortgage market survey, despite negative outlooks by some for the U.S. economy, the economy continues to “churn out jobs,” which is “great” for housing demand. “We have recently seen home sales start to recover and with this week’s rate drop we expect a continued rise in purchase demand,” Freddie Mac said.3

 

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Sources:

1 Li, Y. (2019, March 27). Stable stocks like consumer staples are seen as a good bet when interest rates fall. CNBC. Retrieved from: https://www.cnbc.com/2019/03/27/these-stocks-are-seen-as-a-good-bet-when-interest-rates-fall.html?recirc=taboolainternal

2 Domm, P. (2019, March 26). Goldman says investors are looking at the wrong bond market indicator and a recession is less likely. CNBC. Retrieved from: https://www.cnbc.com/2019/03/26/goldman-says-investors-are-looking-at-the-wrong-bond-market-indicator-and-recession-is-less-likely.html

3 Freddie Mac. (2019, March 28). Mortgage Rates See Biggest One-Week Drop in a Decade. Freddie Mac Primary Mortgage Market Survey. Retrieved from: http://www.freddiemac.com/pmms/

Sources for Financial Data:

U.S. 10 Year Treasury Note:

https://www.bloomberg.com/quote/USGG10YR:IND

S&P 500 Utilities Sector Index:

http://bigcharts.marketwatch.com/historical/default.asp?symb=xx%3Agspu&closeDate=12%2F31%2F18&x=22&y=22

http://bigcharts.marketwatch.com/historical/default.asp?symb=xx%3Agspu&closeDate=3%2F20%2F19&x=40&y=18

http://bigcharts.marketwatch.com/historical/default.asp?symb=xx%3Agspu&closeDate=3%2F27%2F19&x=36&y=25

S&P 500 Consumer Staples Sector Index:

http://bigcharts.marketwatch.com/historical/default.asp?symb=xx%3Agsps&closeDate=3%2F27%2F19&x=26&y=21

http://bigcharts.marketwatch.com/historical/default.asp?symb=xx%3Agsps&closeDate=3%2F20%2F19&x=18&y=25

http://bigcharts.marketwatch.com/historical/default.asp?symb=xx%3Agsps&closeDate=12%2F31%2F18&x=52&y=17

S&P 500 Dividend Aristocrats Index:

http://bigcharts.marketwatch.com/historical/default.asp?symb=SPDAUDP&closeDate=12%2F31%2F18&x=28&y=22

http://bigcharts.marketwatch.com/historical/default.asp?symb=SPDAUDP&closeDate=3%2F27%2F19&x=50&y=23

http://bigcharts.marketwatch.com/historical/default.asp?symb=SPDAUDP&closeDate=3%2F20%2F19&x=35&y=24

S&P/Citigroup U.S. REIT Index:

http://bigcharts.marketwatch.com/historical/default.asp?symb=STCGUSRE&closeDate=12%2F31%2F18&x=34&y=26   

http://bigcharts.marketwatch.com/historical/default.asp?symb=STCGUSRE&closeDate=3%2F20%2F19&x=30&y=21      

http://bigcharts.marketwatch.com/historical/default.asp?symb=STCGUSRE&closeDate=3%2F27%2F19&x=18&y=22      

S&P 500 Financials Sector Index:

http://bigcharts.marketwatch.com/historical/default.asp?symb=xx%3Agspf&closeDate=12%2F31%2F18&x=29&y=25

http://bigcharts.marketwatch.com/historical/default.asp?symb=xx%3Agspf&closeDate=3%2F20%2F19&x=35&y=25

http://bigcharts.marketwatch.com/historical/default.asp?symb=xx%3Agspf&closeDate=3%2F27%2F19&x=25&y=21

KBW Nasdaq Bank Index:

http://bigcharts.marketwatch.com/historical/default.asp?symb=BKX&closeDate=3%2F27%2F19&x=36&y=27                   

http://bigcharts.marketwatch.com/historical/default.asp?symb=BKX&closeDate=3%2F20%2F19&x=22&y=22                   

http://bigcharts.marketwatch.com/historical/default.asp?symb=BKX&closeDate=12%2F31%2F18&x=30&y=26                 

S&P Homebuilders Select Industry Index:

http://bigcharts.marketwatch.com/historical/default.asp?symb=SPHOME&closeDate=3%2F27%2F19&x=36&y=28        

http://bigcharts.marketwatch.com/historical/default.asp?symb=SPHOME&closeDate=3%2F20%2F19&x=26&y=25        

http://bigcharts.marketwatch.com/historical/default.asp?symb=SPHOME&closeDate=12%2F31%2F18&x=38&y=21

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