Wall St week ahead: Plunging bond yields add appeal to stocks ahead of Fed meeting

NEW YORK, March 17 (Reuters) – U.S. stocks have gained an unexpected ally in recent days – a historic drop in bond yields.

U.S. Treasury yields fell sharply this week, with some durations posting their biggest declines in decades, as investors believe the Federal Reserve is likely to moderate its aggressive pace of rate hikes to avoid exacerbating stress on the financial system following the failures of Silicon Valley Bank and Signature Bank.

Volatility in fixed-income markets has unsettled investors, and falling yields may reflect expectations that the central bank will cut interest rates due to a hit to growth.

Meanwhile, falling yields have so far been a boon for stocks, especially technology and other large growth stocks, whose relatively strong performance helped support the benchmark S&P 500 (.SPX). The index rose 1.4% during the week, as the strength of technology stocks outweighed the steep decline in banking stocks.

While the banking crisis has fueled fears of a recession, “the interest rate move is … a tailwind for equities at the moment,” said Charlie McElligott, managing director of cross-asset macro strategy at Nomura.

The direction of near-term yields will likely depend on next week’s Federal Reserve meeting. Signs that the central bank may be prioritizing financial stability and slowing or pausing its interest rate hikes could drag yields even lower. Conversely, yields could rebound if the Fed signals that slowing inflation — which remains high despite rate hikes — will continue to be a task.

“The market is not quite sure how the Fed is going to look at this,” said Garrett Melson, portfolio strategist at Natixis Investment Managers Solutions.

So far, futures markets indicate that investors are giving a 60 percent chance of a 25-basis-point rate hike at the Fed’s May 21-22 meeting. March, with interest rate cuts to follow later this year – a sharp reversal from previously hawkish expectations. in this month.

“For the first time in this cycle of Fed tightening, the Fed must now balance its credibility to fight inflation with stability in financial markets,” said Michael Arone, chief investment strategist at State Street Global Advisors.

Exchange-traded fund yields fell to historic lows after the Fed cut interest rates to support the economy at the start of the COVID-19 pandemic, fueling a stock market rally that saw the S&P 500 double from its March 2020 trough at one point.

When the Fed began tightening monetary policy a year ago to fight inflation, Treasury yields began to rise, providing investors with an even more attractive alternative to stocks. Two-year yields, recently at 3.85%, hit a more than 15-year high of 5.08% earlier this month.

According to some metrics, the recent drop in interest rates has helped stocks regain their appeal. The equity premium, or the extra return investors expect to get from owning stocks over risk-free government bonds, has risen in early January but remains near its lowest level in more than a decade, according to data from Refinitiv.

Other metrics show that stocks are still expensive in historical terms. The S&P 500 trades at 17.5 times forward earnings estimates, compared to its historical average P/E of 15.6 times, according to Refinitiv Datastream.

The rally in interest-rate-sensitive areas such as tech stocks appears to indicate that the market expects interest rates to continue falling as the widely feared recession looms, Nomura’s McElligott said.

The S&P 500 information technology sector ( .SPLRCT ) and communications services sector ( .SPLRCL ) rose more than 5% and nearly 7% this week, boosted by strong gains in Microsoft Corp ( MSFT.O ) and the parent company of Google. Alphabet Inc (GOOGL.O).

However, some investors are skeptical of stock valuations. Bob Kalman, senior portfolio manager at Miramar Capital, said the Nasdaq 100 (.NDX) shouldn’t trade at more than 25 times forward earnings at current rates, below the current 3/27.

“People have this muscle memory to buy mega-caps whenever they get nervous,” Kalman said. “But the Fed hasn’t abandoned the rhetoric, which they know they have to overcome because inflation is a much bigger concern in the economy than a couple of bank failures.”

Reporting by Lewis Krauskopf and David Randall; Editing by Ira Iosebashvili and Richard Chang

Our standard: Thomson Reuters Trust Principles.