Last week, U.S. economic data came in mixed. While U.S. wages appeared to strengthen, most measures of U.S. economic growth continued to disappoint.
Typically, mixed economic data would trigger a bond rally as investors engage in a “flight to quality.” So it was somewhat surprising that investors sold U.S. bonds last week, driving yields higher and prices lower. The yield on the 10-year Treasury, for instance, rose from 1.91% to 2.11%.
The reasons behind this bond sell-off? As I write in my new weekly commentary, the rise in U.S. yields has been driven by higher inflation expectations. Ten-year U.S. inflation expectations have risen by roughly 0.4% from their January low and are now at their highest point since October. While this is still below 2014 levels, higher oil prices, improved European growth and some evidence of stabilizing inflation in Europe appear to have left investors less concerned about the prospect of deflation.
But regardless of what caused last week’s bond sell-off, it provided a foreshadowing of what’s likely to happen to U.S. equities as the eventual Federal Reserve (Fed) rate liftoff nears.
A combination of higher interest rates and mixed company earnings kept U.S. stocks in general under pressure last week. The losses, however, were more severe for rate-sensitive market segments such as U.S. utilities, which lost more than 1.5% on the week.
In other words, last week’s market performance demonstrated that, as I’ve discussed in previous pieces, it doesn’t take much of a yield rise to put downward pressure on the more rate-sensitive parts of the U.S. market, given how stretched valuations are. Such market segments, including utilities, have historically proved more vulnerable to contracting valuations as rates rise, and they’re likely to suffer further assuming that rates rise moderately this year.
Sources: Bloomberg, BlackRock research