Bond Yields’ Jump Could Be a Big Problem for Stocks

By Randall W. Forsyth

Jan. 8, 2021 12:14 pm ET

Treasury Secretary Steven Mnuchin and Federal Reserve Chairman Jerome Powell.

Drew Angerer/Getty Images

In the maelstrom of the past week’s events, it would be understandable if bond yields’ breakout escaped your notice. Yet that development wasn’t unrelated to the political news, in this case the Georgia Senate runoff elections. Those races gave the Democrats 50 seats in the upper house and will give them a narrow edge, with Kamala Harris casting the potential tiebreaking vote after she is sworn in as vice president and presides over the Senate.

With the Dems controlling both houses of Congress and the White House, the odds for additional fiscal stimulus got a big boost. The most likely action would be to top up the $600 household relief checks, approved in 2020’s waning days, to $2,000, an amount President Donald Trump and House Democrats favored but which was opposed by the Republicans who then controlled the Senate.

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“More stimulus, combined with wider vaccinations that allow for a complete reopening of the economy, will be an upside for economic growth in 2021,” Rubeela Farooqi, chief U.S. economist at High Frequency Economics, writes in a client note.

Economists look for another $1 trillion on top of the $900 billion bill passed late last year. To the bond market, such expectations also mean more federal borrowing, potentially higher inflation, and, in turn, higher yields. While the move is mainly symbolic, the 10-year Treasury note has regained the 1 “handle,” trader talk for the number ahead of the decimal, as the benchmark issue’s yield rose past 1%.

Late Thursday, the 10-year note was quoted at 1.102%, the highest since last March, when it hit 1.158%, according to Dow Jones data, and up from 0.955% Tuesday, ahead of the Georgia vote. The 30-year bond’s yield rose to 1.880%, the highest since 1.836% last Feb. 24 and up from 1.649% since the turn of the year. The latter increase doesn’t sound like much, but the resulting price decline in the popular iShares 20+ Year Treasury Bond exchange-traded fund (ticker: TLT) produced a negative total return of 3.75% in the young year through Thursday, according to fund tracker Morningstar. (Bond prices move inversely to yields.)

In addition to bigger checks for households, the anticipated added stimulus could also include aid to state and local governments, which the formerly GOP-controlled Senate had opposed. Apart from the political calculation not to help blue states with their budget woes, there also were contentions that such aid would provide a revenue windfall to states and localities.

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That was a misreading of data, writes longtime municipal finance maven Natalie Cohen in her Public Purse blog. Third-quarter data show much higher revenue than the total a year earlier—because income-tax payment deadlines were extended to July 15 from the traditional April 15. Comparing the relevant quarters when taxes were filed, she finds that individual tax collections were down about $10 billion in the 42 states with an individual income levy. Seasonal adjustments used by the Census Bureau further muddy the waters.

Federal relief for strapped states and localities should benefit municipal bonds, including the high-yield variety, according to the Wells Fargo Investment Institute’s 2021 outlook. Despite the failure to provide state and local aid in the prior stimulus measure, BCA’s U.S. Bond Strategy report maintains, “municipal bond spreads offer more-than-adequate compensation for default/downgrade risk.”

Even before adjusting for munis’ tax exemption, BCA notes, the Bloomberg Barclays Revenue Bond index offers greater yield than a comparable corporate credit index. But yields on high-grade general-obligation bonds have fallen to historic lows, relative to comparable Treasuries, with 10-year maturities yielding only 65%-70% as much as the benchmark note, Bank of America points out in a research note, making them relatively unattractive.

And when the value of the tax exemption is taken into consideration, munis look even better for income investors. That would be even more so if tax rates on the wealthy rise, as proposed by President-elect Joe Biden. The Democratic plan envisions restoring the top bracket of 39.6%, which kicked in for married joint filers at $466,950 before the Tax Cut and Jobs Act of 2017. The current 37% top federal bracket starts at annual incomes of $622,051 for married couples. The Biden plan also would tax dividends and capital gains at ordinary-income rates for those making more than $1 million, adding to tax-free munis’ allure for such high earners.

That attraction will be tempered by the prospect of further rises in Treasury yields, which would ripple through the credit markets, putting upward pressure on long-term interest rates from stronger growth and bigger federal deficits. In addition, two Federal Reserve Bank presidents, Patrick Harker of Philadelphia and Raphael Bostic of Atlanta, this past week raised the possibility of the central bank beginning to pare its $120 billion monthly securities purchases later this year, which also could push up yields.

Investment-grade corporations are rushing to sell bonds ahead of expected yield boosts, Cliff Noreen, head of global investment strategy at MassMutual observes. Nearly $50 billion of new high-grade issues already have been brought to market this year, Bloomberg reports. Heftier long-term interest levels, combined with short-term rates pinned at near zero by the Fed, has produced the steepest yield curve since 2017, our colleague Alexandra Scaggs reports, a big positive for bank earnings. The SPDR S&P Bank ETF (KBE) already had returned 9.35% in 2021 through Thursday, which wouldn’t be a bad full-year haul.

Meanwhile, economists are boosting their yield forecasts. Citigroup now is looking for 2% on the 10-year Treasury, up from 1.50%. And for a stock market trading at an historically high price/earnings ratio—more than 23 times forward estimated earnings, according to Jim Bianco of Bianco Research—a doubling in bond yields from the sub-1% level could be problematic.