US equity markets surged on 31st August, with global markets joining the rally. The S&P 500 index enjoyed its biggest one-day gain in 3 months, capping three successive daily gains. The catalyst for the rally was weaker than expected economic activity data, notably falling new job openings, and fading consumer confidence. It was a case of bad news being good news, at least for Treasury bonds and equity markets. A weaker economy suggests inflation will keep decelerating, removing the need for further Federal Reserve monetary tightening. The prospect of lower inflation and lower short-term interest rates helps push treasury bond yields lower. Bond prices rise as yields drop. End August markets provide a foretaste of what may be in store for Treasury bond markets and equity markets in 2024 and 2025.

Rising bond yields are bad for equity valuations. Equity valuations essentially have two moving parts: Earnings and the Price-to-Earnings ratio. The Price-Earnings ratio comes under pressure when bond yields rise, in particular the 10-year Treasury bond yield, which is the benchmark in global financial markets against which all asset prices are priced. The equity risk premium is the forward earnings yield minus the 10-year Treasury bond yield. The US equity risk premium has dropped sharply this year indicating less value for shareholders. It has dropped to its lowest level since 2002, partly due to rising equity markets but mainly due to the sharp increase in the 10-year Treasury bond yield. The yield has increased from 3.19% to 4.21% over the past 12 months. From current elevated levels, given the compacted equity risk premium, a further sharp rise in the 10-year Treasury yield poses the biggest threat to US and global equity markets.

Some renowned economists including former Treasury Secretary Larry Summers believe the 10-year yield will move higher, premised on persistently strong economic growth, which would require further Fed monetary tightening to quell inflation. These economists believe that the current Fed funds rate, despite rising by 525 basis points since 2022, is not yet in restrictive territory. They believe continued economic strength will prevent inflation from returning to the 2% G7 central bank targets.

Others feel a US recession is just around the corner. The lag between the current interest rate hiking cycle and recession has been longer than usual due to massive pandemic handouts, amounting to some $5 trillion. By swelling household savings, the extraordinary pandemic fiscal relief made consumers less susceptible than normal to rising interest rates. Nonetheless, a recession is expected to arrive as excess savings are being depleted while consumers and businesses will eventually have to refinance at higher prevailing interest rates. The Conference Board’s Leading Economic Indicator (LEI) has dropped for 13 consecutive months. According to independent research firm Alpine Macro, the US economy has never avoided recession after such a long string of LEI declines and the current annual rate of LEI contraction.

Alpine Macro also believes inflation is coming down. Excluding shelter, core CPI has already fallen from a peak of 7.6% year-on-year to 2.6%. According to the San Franciso Federal Reserve Bank, shelter inflation is moving sharply lower and could turn negative in the second half of 2024. If core CPI excluding shelter remains unchanged at 2.6%, this means overall core CPI might fall to as low as 0.3% by late 2024. Alpine Macro believes 10-year Treasury bond yields are close to their cyclical top and likely to head lower.

Capital Economics, another independent research firm, shares the view on bond yields. It believes a mild recession is in the offing but also that inflation and bond yields will come down regardless of the strength of economic activity. Over the past eight Fed monetary tightening cycles, the 10-year yield fell by an average 130 basis points in the six months following the last interest rate hike. Futures markets are discounting only a small chance of a further rate hike at the upcoming Fed policy meeting on 19-20 September. The greater likelihood is that the July rate hike was the last in the current tightening cycle. Capital Economics forecasts falling inflation, a mild recession and the 10-year yield dropping to 3.25% by the end of this year and 3.0% by end 2024.

Provided the recession is mild, a sharply lower 10-year yield should be very positive for balanced investment portfolios. As yields fall bond prices rise. Equity markets will also rally, as the lower bond yield will create more attractive equity risk premia and the potential for higher Price-to-Earnings multiples. Capital Economics forecasts global equity markets will drop between now and the end of the year by 10% due to mild recession but following that a substantial 30% return in 2024 and a further 30% in 2025, in line with falling bond yields and a gradual economic recovery.

Nothing is certain in financial markets. Other analysts, although in the minority, believe that instead of retreating to 3.0% by end 2024, the 10-year yield could go in the other direction, potentially hitting 5.0%. A combination of other factors besides inflation and the Fed funds rate could contribute to a yield spike including the downgrading of US sovereign credit risk by Fitch rating agency, the deteriorating US budget deficit, and the unusually large sovereign debt issuance schedule. Moreover, the Bank of Japan has abandoned its cap on 10-year Japanese Government Bond (JGB) yields. Rising JGB yields will cause Japanese institutions to sell US Treasuries in favour of JGBs which for the first time in over a decade are offering reasonable yields.

Overberg Asset Management takes the view that the 10-year yield is close to peak levels and that the next two years will be good for financial markets, although nothing is certain. In the event of a bond yield spike or a deeper than anticipated recession, some risk mitigation needs to be in place through protective asset class weightings and effective portfolio diversification.