EXPLAINER: Why economic optimism unsettled Wall Street

Rising expectations for the economy and inflation have caused U.S. Treasury yields to spurt higher, with the jump unsettling stock markets

Explainer-Wall Street Rate Fears (Copyright 2020 The Associated Press. All rights reserved)

Yes, it’s possible to have too much of a good thing, and that’s exactly why stock markets around the world are getting so unsettled.

Optimism for an economic revival is surging following a year of coronavirus-induced misery. But expectations for stronger growth — plus the higher inflation that could accompany it — are pushing interest rates higher, which is forcing investors to re-examine how they value stocks bonds and every other investment.

When it tries to figure out the value for anything from Apple’s stock to a junk bond, the financial world starts by comparing it against a U.S. Treasury bond, which is what the government uses to borrow money. For years, yields have been ultralow for Treasurys, meaning investors earned very little in interest for owning them. That in turn helped make stocks and other investments more attractive, driving up their prices. But when Treasury yields rise, so does the downward pressure on prices for other investments.

All eyes have been on the yield of the 10-year Treasury note, which climbed above 1.50% this week after starting the year around 0.90%. Here’s a look at why that move shook up the financial world, including the worst week for the Nasdaq composite since October:

WHY ARE TREASURY YIELDS RISING?

Part of it is rising expectations for inflation, perhaps the worst enemy of a bond investor. Inflation means future payments from bonds won't buy as many bananas, minutes' worth of college tuition or whatever else is rising in price. So bond prices tend to fall when inflation expectations are rising, which in turn pushes up their yields.

Treasury yields also often track with expectations for the economy’s strength, which are on the rise. When the economy is healthy, investors feel less need to own Treasurys, considered to be the safest possible investment.

WHY DO FALLING BOND PRICES MEAN RISING YIELDS?

Say I bought a bond for $100 that pays 1% in interest, but I'm worried about rising inflation and don't want to be stuck with it. I sell it to you for $90. You're getting more than a 1% return on your investment, because the regular payouts coming from the bond will still be the same amount as when I owned it.

WHY ARE INFLATION AND GROWTH EXPECTATIONS RISING?

Coronavirus vaccines will hopefully get economies humming this year, as people feel comfortable returning to shops, businesses reopen and workers get jobs again. The International Monetary Fund expects the global economy to grow 5.5% this year following last year's 3.5% plunge.

A stronger economy often coincides with higher inflation, though it's been generally trending downward for decades. Congress is also close to pumping another $1.9 trillion into the U.S. economy, which could further boost growth and inflation.

WHY DO RATES AFFECT STOCK PRICES?

When trying to figure out what a stock's price should be, investors often look at two things: how much cash the company will generate and how much to pay for each $1 of that cash. When interest rates are low and bonds are paying little, investors are willing to pay more for that second part. Consider a stock like Apple or another Big Tech company, which will likely keep generating large amounts of cash many years into the future. It's more worthwhile to wait a long time for that if a 10-year Treasury is paying less in the meantime.

AND NOW THAT RATES ARE RISING?

The recent rise in yields is forcing investors to pare back how much they're willing to spend on each $1 of future company earnings. Stocks with the highest prices relative to earnings are getting hit hard, as are stocks that have been bid up for their expected profits far in the future. Big Tech stocks are in both those camps. Dividend-paying stocks also get hurt because investors looking for income can now turn instead to bonds, which are safer investments.

The ultimate worry is that inflation will take off at some point, sending rates much higher.

AREN'T INTEREST RATES STILL REALLY LOW?

Yes, even at 1.50%, the 10-year Treasury yield is still below the 2.60% level it was at two years ago or the 5% level of two decades ago.

“The concern isn’t that the 10-year is at 1.50%,” said Yung-Yu Ma, chief investment strategist at BMO Wealth Management. “It’s that it went from 1% to 1.50% in a handful of weeks, and what does that mean for the rest of 2021.”

Ma thinks it could keep rising above 2% by the end of the year, but he doesn’t see it going back to the old normal of 4% or 5%, which would force an even bigger reassessment for markets. Until that becomes more clear, though, he says he’s looking for the stock market to stay volatile.

AREN'T STOCKS STILL REALLY HIGH?

Yes. Despite the recent pullback in the market, the major U.S. stock indexes remain near all-time highs set earlier this month. The benchmark S&P 500 index and Nasdaq each hit all-time highs on Feb. 12. The Dow Jones Industrial Average set a record high on Wednesday. And the Russell 2000 index of smaller companies notched an all-time high on Feb. 9.

HASN'T THE FED SAID IT WILL KEEP INTEREST RATES LOW?

Yes. The Federal Reserve has direct control over short-term interest rates, and Chair Jerome Powell told Congress this week it's in no hurry to raise them. It's also not planning to trim its $120 billion in monthly bond purchases used to put downward pressure on longer-term rates.

Powell said the Fed won’t raise its benchmark interest rate, now at its record low of zero to 0.25%, until inflation runs slightly above its 2% target level. Powell told Congress that while price increases might accelerate in coming months, those increases are expected to be temporary and not a sign of long-run inflation threats.

IS WALL STREET STILL OPTIMISTIC?

Yes, and one reason is that many investors agree with Powell and expect inflation pressures to be only temporary. That should hopefully keep rates from spiking to dangerous levels.

Also, after a dismal 2020 for most companies, investors are banking that corporate earnings will improve in the second half of this year as the coronavirus vaccination efforts broaden and the economy gradually begins approaching something close to normal. If earnings rise, stocks can stay stable or maybe even rise.

DO SOME COMPANIES DO WELL WHEN RATES ARE RISING?

Financial companies, particularly banks, have gained recently because rising rates can mean bigger profits made on a variety of consumer loans, including mortgages. And if rates are rising on inflation worries, energy companies could benefit if prices are also rising for oil and other commodities.

Overall, though, rising interest rates are a drag on companies because they make borrowing more expensive. This is especially painful for companies like real estate investment trusts, or REITs, which require a lot of money, and often debt, to operate.

People who rely heavily on credit may also cut back, which could have a ripple effect on all kinds of companies that rely on consumer spending.