Moody’s: Higher Treasury Yields Expected as Equities Surge

The firm points to stock rally and lower junk yields as key to New Year market sentiment.

Risk-on trades are powering into the new year, and John Lonski, Moody’s chief economist, thinks the benchmark 10-year Treasury’s yield will continue to rise.

In a research note, Lonski points to the stock market rally—the Standard & Poor’s 500 has advanced 4.5% thus far in 2018—and a drop in the junk bond composite yield this year, to 5.72% from 5.82%. That means investors are buying the bonds, whose price moves in the opposite direction from yield.

Stocks and speculative bonds are the quintessential risk-on trades, meaning investors have faith in their return potential, and are willing to stomach their higher risk.

The other part of that equation, certainly, is the out-of-favor risk-off trade, most typically the 10-year Treasury note, which the federal government stands behind and whose risk is judged by most as nearly nil. Demand for the 10-year has dropped, and its yield has risen to 2.64% as of Friday from 2.41 at year-end 2017. That, Lonski writes, is “largely in response to the upwardly revised outlook for real returns that are implicit to the equity rally and the drop by the speculative-grade bond yield.”

Lonski expects continued increase in the 10-year’s yield until the stock market stagnates or junk yields climb, as represented by the spread between them and (lower) investment-grade corporate yields. Then investors would crowd back into the safer Treasury, and its yield would dip. Another sign of a possible shift toward lower T-note yields, he suggests: If there’s a slide in the industrial metals price index, which could herald economic weakness ahead. The S&P GSCI Metals Index is up almost 20% over the past 12 months.

The yield on the 10-year Treasury has come a long way since it touched 1.5% in July 2016, as the stock market moved sideways and oil prices were just coming out of an epic slump.

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