Key points in this equity note:
- Long-term bond yields are breaking higher with the US 10-year yield pushing above 4% introducing a new dynamic in the US equity market that most had been downplaying for months during the AI rally.
- The VIX Index has jumped significantly today coming out of its hibernation and the VIX futures forward curve is getting closer to inversion signaling nervousness.
- With the cost of capital on the rise the stakes have been raised going into the Q2 earnings season. Higher discount rate on cash flows can only be offset by higher growth outlook so the Q2 earnings season is now paramount maintaining the strong equity sentiment this year.
A new dynamic is in play
We have been highlighting it multiple times in our daily podcast over the past couple of weeks. Inflationary pressures are still strong in the economy and the market would be surprised about central banks’ policy trajectory. The FOMC Minutes last night suggested more hawkish FOMC voting members than what was priced in and it immediately lifted bond yields across the board. We had flagged the possibility of the US 10-year yield breaking out above the 4% level and today it happened. We wrote the following on US equities in our morning Quick Take report:
US bond yields are moving higher as FOMC Minutes showed that most of the policymakers agree that more tightening is needed this year. If the US 10-year yield breaks above 4% and marches on to challenge the previous cycle highs around the 4.25% it could change the dynamics in the US equity markets. With rising bond yields a positive Q2 earnings season becomes more important to justify the current equity valuations under rising yields.
With the US 10-year yield marching higher with high energy trading at 4.05% of this writing the dynamics in US equities have indeed changed. S&P 500 futures are down 1.3%, the biggest decline since 25 April, erasing most of the recent gains. The VIX Index is jumping significantly in today’s session trading around 16.64 introducing suddenly a change of sentiment. The VIX futures forward curve has inched closer to inversion with the 2nd nearest contract trading only 1.4 points above the spot index which is lowest positive spread since the hectic days during the US banking crisis.
The higher US 10-year yield lifts the cost of capital and thus lower the present value of future cash flows, so unless the higher 10-year yield reflects higher growth it could cause a repricing lower of equities. With the rally in technology stocks due to AI, the US equity market has reached equity market valuations that make it more sensitive to these breakouts in bond yields. Because growth is important to offset higher cost of capital the stakes have been raised going into the Q2 earnings season. A normal small correction in equities as reality turns out not to be able to support elevated expectations is often in the 5-7% range which in the case of S&P 500 future could take those futures down to the 4,200 level. Whether a future path leads to this area will depend on what long-term bond yields do from here and whether companies disappoint or not on Q2 earnings against elevated expectations. It could turn out to be stormy summer.