What happened in the markets - 16-20 Oct 2023

Introduction

The past week was a tough one for the U.S. Stock Market. The S&P 500 Index experienced its largest weekly decline in a month, seemingly due to geopolitical concerns, stern words from Federal Reserve officials, and a surge in long-term bond yields to new 16-year highs. The Nasdaq Composite Index was the hardest hit among the major benchmarks, nearly slipping back into bear market territory, ending the week 19.91% below its early-2022 intraday highs. Consequently, growth stocks trailed behind their value counterparts. The week kicked off on a positive note, marking the 15th consecutive Monday of gains for the S&P 500, seemingly buoyed by a lack of negative news regarding the Middle East over the weekend. However, escalating tensions later in the week seemed to erase these gains. Shares took a sharp dive on Thursday afternoon following reports that a U.S. Navy destroyer had intercepted a cruise missile apparently aimed at Israel. News of a drone attack on a U.S. base in Iraq also appeared to dampen investor sentiment, according to T. Rowe Price traders.

Key Takeaways

This week, market tension rose as Treasury bond yields increased. The 10-year Treasury yield is nearing 5%, a level not seen since 2007. The two-year yield, which typically follows the fed funds rate, also hit a peak of around 5.15% as the Federal Reserve considers the possibility of another interest rate hike.
The sharp rise in bond yields has increased volatility in stocks and bonds. Last week, the S&P 500 dropped by over 1.5%, and the Bloomberg U.S. Aggregate bond index was down over 2%. Higher yields can raise borrowing costs, lower stock values, and impact bond prices.
Although yields may temporarily exceed expectations, analysts anticipate government bond yields to stabilize as the Federal Reserve and global central banks halt rate hikes and shift towards lower rates. However, 10-year yields may continue to be higher compared to historical levels in the post-pandemic era, potentially ranging from 3.5% to 4.5%.

What is driving yields higher?

The recent rise in 10-year bond yields. Here are three key factors driving this trend:

1. A resilient economy The U.S. economy has been showing remarkable resilience, defying recession predictions and maintaining above-trend growth for the first three quarters of the year. With an expected annualised real GDP growth of around 3% in the third quarter, the economy is performing well above the trend growth of 1.5% to 2%. This is largely due to a robust labor market and a strong consumer base. This stronger-than-expected growth also exerts upward pressure on Treasury yields, as these yields partly reflect the economy's growth prospects over time. However, we might see some economic cooling in the coming quarters, especially if the labor market softens and consumption cools due to lower savings rates and higher overall debt levels. This moderation could also ease the ongoing upward pressure on Treasury yields.

2. Supply/demand imbalances With the U.S. fiscal deficit growing, the Treasury Department has been increasing its auction sizes for U.S. Treasury bills and notes, adding more government bonds to the market. This year, the total amount of Treasuries issued in auctions is expected to exceed $3 trillion, a figure higher than any year over the past decade (excluding the 2020 pandemic surge). This figure is expected to increase next year. At the same time, some of the natural demand for these bonds has moderated. The Federal Reserve is undertaking quantitative tightening, allowing Treasury bonds to roll off its balance sheet and reducing its holding of Treasuries by about $650 billion over the last year. Some foreign buyers, such as China, have also been slowly reducing their holdings of U.S. Treasuries. However, other countries have increased their purchases as yields have risen, offsetting these reductions. But overall, with growing supply and waning demand, Treasury yields have increased, partly to attract more buyers.