Wondering how to play rising bond yields? Then start betting on an improving economy.
U.S. bond yields have been the market highlight of the week. The yield on the 10-year U.S. Treasury bond jumped above 2.1 per cent on Tuesday, to its highest level in more than a year and up from 1.63 per cent as recently as the start of May.
The yield on the five-year bond has been similarly impressive, rising above 1 per cent on Tuesday, from 0.65 per cent at the start of May.
Nothing moves in a straight line, of course, and bond yields retreated slightly on Wednesday amid a global stock market downturn – but the trend seems to be alive. Pat Chiefalo of National Bank Financial believes that the yield on the 10-year bond could be moving toward a test of 2.4 per cent, or close to a two-year high, "with further potential upside if this key level is breached."
The reasons behind these yield moves could be good news. As Paul Krugman noted on his New York Times blog, three different stories tend to accompany a rise in yields: Bond vigilantes are selling U.S. debt because of debt fears; the Fed has changed its view on economic stimulus; or Fed policy remains the same, but the market believes it will raise rates sooner than expected because of an improving economy.
Mr. Krugman believes the evidence points to story No. 3: "Debt fears – basically, a run on America – should send stocks and the dollar down along with bonds. A perceived tougher Fed should send stocks down but the dollar up. And a better recovery should send both stocks up (because of higher expected profits) and drive the dollar higher."
That sounds about right, especially when you consider that this week's leap in bond yields was accompanied by two head-spinning economic reports. The S&P/Case-Shiller home price index rose 10.2 per cent in the first quarter, year-over-year – its biggest increase since 2006.
As well, the Conference Board's consumer confidence index rose to 76.2 in May, up from 68.1 last month and the highest reading in more than five years.
Now what? The stock market seems to be providing a clear answer: Get into economically sensitive stocks.
In the first quarter of the year, defensive stocks led the gains of the broader S&P 500. Health-care stocks were the top performers, rising 15.2 per cent. Consumer staples and utilities placed second and third.
Since the start of May, though, a dramatic shift has been unfolding. Now, financials are leading the way, with a gain of 6.4 per cent. Industrials, energy stocks and technology stocks complete the biggest four movers.
As for those winners in the first quarter, utilities have fallen more than 9 per cent in May, staples are flat and health-care stocks are up but trailing the index.
It's sometimes difficult to see a robust economy ahead, with U.S. unemployment at 7.7 per cent, the euro zone in recession and China slowing down. But the market is starting to bet that better times are on the way.