Companies sensitive to changes in the yield on 10-year Treasury notes are leading the market, suggesting that some equity investors have been premature in anticipating higher interest rates.
The Rate-Sensitive Basket of stocks maintained by Goldman Sachs Group Inc. has outpaced the Standard & Poor’s 500 Total Return Index by 4.5 percentage points since Dec. 31, trading near levels last reached in August 2011 on a relative basis. Meanwhile, yields on 10-year Treasury notes have fallen this year to 1.74 percent as of 9:25 a.m. in New York from 1.76 percent on Dec. 31 and are about 1 percentage point below the August 2011 peak.
This suggests that equity investors may be “jumping the gun a bit” in predicting the Federal Reserve will shift from its accommodative policies, said Tim Ghriskey, chief investment officer of Solaris Asset Management LLC and co-founder of New York-based Solaris Group, which oversees more than $1.5 billion in assets. That’s because the index is designed to rise faster than the broader market when interest rates are rising and historically has tracked such changes, he said.
“We may be witnessing a false start by some equity investors as there’s been no sign of inflationary pressure that would prompt the Fed to raise rates in the near term,” Ghriskey said. The Goldman Sachs basket -- comprised of 50 companies including ethanol maker Valero Energy Corp. (VLO) and gravel producer Vulcan Materials Co. (VMC) -- probably will lag behind the broader market to align with current bond yields, given the “strong correlation” among these assets, he said.
“The relative outperformance of these stocks now shows signs of waning,” said Jim Stellakis, founder and director of research at Greenwich, Connecticut-based research company Technical Alpha Inc. and also a chartered market technician. Since the Goldman Sachs basket traded to a so-called double-top in February and March relative to the broader market, investors have been allocating less money into this group as a seven-month rally appears to have stalled, he said.
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“Some equity investors may have gotten ahead of themselves” as they resorted to an “old Wall Street saw that when the Fed is printing money, there has to be inflation,” said Rob Morgan, who oversees $1 billion as chief investment strategist in Exton, Pennsylvania, at Fulcrum Securities LLC. This seems premature because “there is just no evidence of that in the inflation pipeline.”
The central bank’s preferred gauge for price increases, the personal-consumption expenditure index, rose 1.3 percent in February from a year earlier and has averaged 1.8 percent since the 18-month recession ended in June 2009, according to data from the Commerce Department. That’s below the Fed’s 2 percent target.
Investors probably began to anticipate late last year that interest rates would rise, swayed in part by an apparent divide among Federal Open Market Committee members about when to end the central bank’s $85 billion monthly bond-purchasing program, Morgan said.
“A few members expressed the view that ongoing asset purchases would likely be warranted until about the end of 2013,” while a few others specified no time frame, according to the minutes of the committee’s December meeting released on Jan. 3. “Several others thought that it would probably be appropriate to slow or stop purchases well before the end of 2013, citing concerns about financial stability or the size of the balance sheet.”
Less than eight weeks later, Fed Chairman Ben S. Bernanke defended the central bank’s unprecedented asset purchases, saying they are supporting the expansion.
“We do not see the potential costs of the increased risk-taking in some financial markets as outweighing the benefits of promoting a stronger economic recovery,” he said Feb. 26 in testimony to the Senate Banking Committee in Washington.
“Given that he’s the chairman, we should probably abide by what Bernanke says, so that dovish stance on inflation will likely hold,” said Ioan Smith, a strategist at Knight Capital Europe Ltd. in London. Recently released economic reports also have been “lackluster,” which supports a low federal funds rate, he said. The Fed cut the target for its benchmark rate to near zero in December 2008.
U.S. retail sales unexpectedly fell 0.4 percent last month, the most in nine months, following a 1 percent gain in February, based on figures from the Commerce Department. The median forecast of economists surveyed by Bloomberg called for sales to remain unchanged.
The Institute for Supply Management’s factory index fell to 51.3 (NAPMPMI) in March from an almost two-year high of 54.2 the prior month, according to figures from the Tempe, Arizona-based group. U.S. employers added 88,000 workers in March, less than half the 190,000 forecast in a Bloomberg survey of economists and below the first quarter’s 168,000 average, data from the Labor Department show.
“For the Fed to take its foot off the pedal, nonfarm-payroll hiring needs to be above 200,000 for at least six to seven months and inflation needs to rise above its target,” Smith said.
Rates remain low also because there’s “so much slack in global manufacturing capacity” that hasn’t been adequately factored into investors’ models, while declining commodities suggest consumer prices aren’t rising fast enough for the Fed to change its stance, Morgan said.
In its most-recent meeting, the FOMC reiterated that it will keep the target range for the federal funds rate close to zero as members agreed that it would be appropriate to maintain the existing “highly accommodative stance of monetary policy,” according to the minutes released April 10.
The minutes again showed that several officials said the central bank should begin tapering its quantitative easing program later this year and stop it by year-end. This suggests there’s still debate among policy makers, Smith said, adding that investors have been trying to make sense of some “very confusing messages” as there could be an ideology shift ahead of Jan. 31, when Bernanke’s term ends.
If U.S. economic growth were to accelerate faster than the Fed is forecasting, this could hasten higher rates. “A lot of people are asking me for ideas to protect against inflation” in anticipation of such an outcome, Smith said.
“If a portfolio manager has a view that 10-year yields will be rising, this is a group of stocks that is likely to do well,” said David Kostin, chief U.S. equity strategist at New York-based Goldman Sachs. The company’s economics group forecasts Treasury yields will increase to 2.5 percent by year-end. Investors who share a similar outlook may be interested in the stocks in the rate-sensitive basket, which are “likely to outperform the broader equity market during this horizon.”
It’s important for central bankers to provide visibility about policy changes so as not to “shock the markets,” Ghriskey said.
“This is a very slowly evolving cyclical recovery, and the Fed doesn’t want to stomp on that or interrupt it in any way by raising the federal funds rate too early because this would squash economic growth.”
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