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Market Extra: Why U.S. stocks keep hitting records as yield curve flattens

U.S. stock benchmarks rose to record highs Thursday as investors appeared to shrug off concerns over growth and inflation as the economy recovers from the pandemic.

Although rates are moving up and inflation is higher, that really isn’t being reflected in longer-term Treasury yields, Ralph Bassett, head of North American equities at abrdn told MarketWatch on Thursday. Within the stock market, “I think that’s why you see, more broadly, strength in technology today,” he said by phone. 

The tech-heavy Nasdaq Composite index

rose to a new peak Thursday, while the S&P 500 index
which has large exposure to tech, also notched an all-time closing high as companies continue to report strong earnings for the third quarter.

Tech and high-growth companies are viewed as particularly sensitive to rising interest rates, a concern investors have been weighing in recent months as they watch for any shifts by the Federal Reserve toward tightening its monetary policy through rate hikes, according to Bassett.

The bond market’s yield curve has flattened as investors price in a tightening cycle, said Tom Graff, head of fixed income at Brown Advisory, in a phone interview Thursday. But while rates on the short end of the curve have risen, the long end hasn’t steepened, as the market appears to expect that inflation will be kept under control by the Fed, he told MarketWatch.

“Markets are pretty convinced that it won’t take much to wrangle the recent inflation spike,” Graff said. As for his own expectations for Fed policy, he said he is “leaning toward” two rate hikes by the central bank next year after completing the tapering of its monthly bond purchases by mid-2022.

Rate hikes are a tool the Fed may use to knock down inflation, though some worry doing so will kill the economic recovery.

Earlier this year, investors were worrying about growth peaking during the second quarter, with risks of stagflation moving onto the radar screens of some market analysts as the delta-variant wave of the coronavirus was beginning to surge in the U.S. While delta hurt the economy in the third quarter, COVID-19 cases appear to be subsiding and some investors expect that growth in 2022 will remain above the long-term trend in the U.S.

See: U.S. economy stumbles in third quarter

“Next year we should still exhibit outsized growth given the resurgence of the economy,” said Bassett. While inflationary pressures remain a concern for the economy and corporate profit margins, he said that stagflation worries seem to be largely “brushed off” by the market lately.

Read: Why it’s wrong to compare today’s inflation surge to 1970s-style ‘stagflation’

Bassett told MarketWatch that he expects the Fed to begin tapering this year and to hike rates twice in 2022, beginning in June. Rising rates are a concern for high-growth equities, as Treasury yields feed into models used to calculate their valuations. Higher discount rates make those valuations appear lower, he explained.

Investors typically use the 10-year Treasury yield
he added, which has dipped in recent days. The yield on the 10-year Treasury note traded around 1.57% Thursday, down from about 1.67% a week ago, according to Dow Jones Market Data.

Navigating the economic recovery in the pandemic has been somewhat difficult for investors.

“It’s really hard to decipher what is true underlying growth,” said Bassett, partly because of government stimulus but also due to supply-chain constraints that have “curtailed” demand. 

Graff also pointed to “mixed signals right now” from many moving parts of the rebound, saying the “sugar rush” of growth will come down but the economic recovery probably will remain “strong” next year.

With the Federal Open Market Committee meeting scheduled next week, Graff said he will be listening closely to Fed Chair Jerome Powell’s messaging on the progress the central bank sees in the labor market as part of its dual mandate in setting monetary policy.

“I just think it’s a pipe dream” that there’s a “magic moment” where all the people who dropped out of the labor market are suddenly coming back, said Graff. “Labor looks pretty tight to me.”

Editor’s note: This story has been updated to reflect the recent name change of Aberdeen Standard Investments to abrdn.

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