Why Higher Rates Are Good For Stocks

By Bryan Rich 

September 12, 2016, 5:00pm EST

We headed into the weekend with a market that was spooked by a sharp run up in global yields.  On Friday, we looked at the three most important markets in the world at this very moment: U.S. yields, German yields and Japanese yields.

On the latter two, both German and Japanese yields had been deeply in negative yield territory.  And the perception of negative rates going deeper (a deflation forever message), had been an anchor, holding down U.S. market rates.

But in just three days, the tide turned.  On Friday, German yields closed above the zero line for the first time since June 23rd.  Guess what day that was?

Brexit.

And Japanese 10-year yields had traveled as low as 33 basis points.  And in a little more than a month, it has all swung back sharply.  As of today, yields on Japanese 10-year government debt are back in positive territory – huge news.

So why did stocks rally back sharply today, as much as 2.6% off of the lows of this morning – even as yields continued to tick higher?  Why did volatility slide lower (the VIX, as many people like to refer to as, the “fear” index)?

Here’s why.

First, the ugly state of the government bond market, with nearly 12 trillion dollars in negative yield territory as of just last week, served as a warning signal on the global economy.  As I’ve discussed before, over the history of Fed QE, when the Fed telegraphed QE, rates went lower.  But when they began the actual execution of QE (buying bonds), rates went higher, not lower (contrary to popular expectations).  Because the market began pricing in a better economic outlook, given the Fed’s actions.

With that in mind, the ECB and the BOJ have been in full bore QE execution mode, but rates have continued to leak lower.

That sends a confusing, if not cautionary, signal to markets, which is adding to the feedback loop (markets signaling uncertainty = more investor uncertainty = markets signaling uncertainty).

Now, with government bond yields ticking higher, and key Japanese and German debt benchmarks leaving negative yield territory, it should be a boost for sentiment toward the global economic outlook. Thus, we get a sharp bounce back in stocks today, and a less fearful market message.

Keep in mind, even after the move in rates on Friday, we’re still sitting at 1.66% in the U.S. 10-year. Before the Fed pulled the trigger on its first rate hike, in the post-crisis period, the U.S. 10-year was trading around 2.25%.  As of last week, it was trading closer to 1.50%.  That’s 75 basis points lower, very near record lows, AFTER the Fed’s first attempt to start normalizing rates.  Don’t worry, rates are still very, very low.

Still, the biggest risk to the stability of the bond market is, positioning:  The bond market is extremely long. If the rate picture swung dramatically and quickly higher, the mere positioning alone (as the longs all ran for the exit door) would exacerbate the spike.  That would pump up mortgage rates, and all consumer interest rates, which would grind the economy to a halt and likely destabilize the housing market again. And, of course, the Fed would be stuck with another crisis, and little ammunition.

As Bernanke said last month, the Fed has done damage to their own cause by so aggressively telegraphing a tighter interest rate environment. In that instance, he was referring to the demand destruction caused by the fear of higher rates and a slower economy.  But as we discussed above, the Fed also has risk that their hawkish messaging can run market rates up and create the same damage.

Bottom line:  The Fed is walking a fine line, which is precisely why they continue to sway on their course, leaning one way, and then having to reverse and shift their weight the other way.

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