Friday’s strong jobs report drives a market selloff
On Friday, the US got a surprisingly strong jobs report. The economy added +256k jobs in December – 90k more than consensus estimates – and the unemployment rate unexpectedly slipped to 4.1%.
In response, 10-year Treasury yields rose +8bps to 4.75% – their highest in over a year – and major equity indices fell about -2%.
10-year rates, rising on resilient economy and stubborn inflation, becoming headwind to equities above 4.4%
10-year Treasury yields have actually been increasing pretty steadily since mid-September – they’re up +115bps over that time (chart below, black line).
This upward trajectory has been driven by a few factors:
- real rates increasing as data has consistentlyshown the US economy holding up better than expected in the face of still-high interest rates
- inflation expectations rising as inflation has stayed above the Fed’s 2% target
- and the pricing in of potential policy changes that could extend these two trends.
Looking at the chart below, you’ll see that, since the September low in Treasury yields, equity prices (blue line) rose in tandem with Treasury yields… to a point.
Once 10-year Treasury yields moved above 4.4% (red line) in mid-December, further increases in Treasury yields were met with falling equity prices.
And we’ve actually seen this pattern play out consistently over the last year or so (red areas). Yet, when Treasury yields have been under 4.4%, we’ve seen equity prices and bond yields rising together (green areas).
Higher rates make high valuations harder to sustain
There’s nothing magical about this 4.4% threshold. It’s just been the point at which markets have started to worry about equity valuations in the last year or so.
Since investors are paying for a company’s future stream of earnings, rates matter to how they value companies. When rates rise, it becomes costlier to borrow to fund operations so they can realize those future earnings. That makes higher PE valuations harder to justify – and PEs are currently high for large caps.
So, by equities selling off, it helps bring down PEs to levels markets are comfortable with.
The question for equity markets is where rates go from here.
Some think 10-year rates could rise to 5% (or higher), which would be a headwind to further equity gains. Of course, one disappointing data print (or lower inflation data) might push yields lower. We’ll be watching Wednesday’s CPI data.
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