Interestingly, the 10-year U.S. Treasury note recorded both its lowest and highest yields of the year in May. The low yield of 1.66%, reached May 1, likely owed to weaker economic data and exceptionally low inflation data. One measure of U.S. inflation, the "personal consumption expenditures deflator," excluding food and energy, which is closely watched by central bank policymakers, has steadily declined since mid-2012. In April, it stood just 1.05% above its year-earlier level, the smallest 12-month rise in the more than 50-year history of the series. Both bond and equity bulls figured that the Federal Reserve's $85 billion-per-month bond buying program would remain intact, since inflation is running well below the Fed's 2.0% target. As May progressed, not only did economic data improve, but debate intensified about how soon the Federal Reserve would "taper" its bond buying program. On May 22, the minutes of the April 30–May 1 Federal Open Market Committee meeting were released. The specific language that fueled the "taper tantrum" was:
"A number of participants expressed willingness to adjust the flow of purchases downward as early as the June meeting if the economic information received by that time showed evidence of sufficiently strong and sustained growth."
The fear of a less accommodative Fed exacerbated the backup in yields and also resulted in a 2.2% decline in the S&P 500 between May 21 and May 31. In an era where central bankers act as central planners, obscuring market signals, perceived changes in the timing of Fed tapering, or in the magnitude of its asset purchases, can materially impact markets. The rise in yields cited above is significant given their low starting point.
Cyclical stocks foreshadowing future strength?
Cyclical sectors—namely, financial (+3.8%), industrial (+2.5%), and technology (+2.2%)—propelled the S&P 500 Index in May, while defensive sectors were pounded (utilities, –11.7%; telecom, –9.5%; staples, –4.5%). Although sectors closely tied to interest rates significantly underperformed, bulls are citing the renewal of cyclical strength, after a mid-March to mid-April retreat, as a positive sign.
Japan: Higher yields, expected rates of inflation curb stock rally
After the December 26, 2012 election of Shinzo Abe, a proponent of central bank asset purchases and the end of deflation, the Japanese yen plummeted and Japan's equity markets caught a strong winter tailwind. However, it was not until April 4 that the newly appointed board of the Bank of Japan (BOJ) announced that it would buy ¥7 trillion—around $70 billion—of Japanese government bonds (JGBs) per month, until it had doubled the monetary base. The BOJ was hoping to reduce JGB yields and thereby lower borrowing costs for Japanese businesses. The opposite transpired. After touching a low of 0.44% on April 4, the 10-year JGB yield soared, reaching 0.93% on May 29 before settling back to 0.85% on May 31.
Before the elections, the average rate of inflation expected by investors over the next five years—implied by the difference in yields between conventional and inflation-linked 5-year JGBs—had been less than 0.80%. By early April, the government apparently had convinced investors to expect 1.40%. By May 15, the April 4 BOJ action had pushed expected inflation to 1.84%. At May 31, expected inflation remained relatively high, at 1.61%. Ironically, government jawboning on a 2.0% inflation target—and the rise in inflation expectations—undermined the BOJ's efforts to suppress yields.
The increase in JGB yields during the six weeks following the April 4 action halted the depreciation of the yen and took the tailwind out of the sails of Japanese equities. The yen had reached a trough of 103.2 per dollar on May 17 and had appreciated slightly to 100.7 by May 31. The capitalization-weighted TOPIX stock market index had peaked on May 22, and by May 31, had declined by 11% from its peak.
Still, at May 31, the yen was 14% lower, and the TOPIX 32% higher, than their levels at the time of Abe's election. Incidentally, U.S. and eurozone authorities find a yen of around 100–105 per dollar, to be fairly valued. While we expect greater volatility, we do not expect a significant reversal of either the yen or the TOPIX.
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