What's Up With Yields

S&P believes elevated inflation worries and increased repatriation of foreign investments are causing rates to climb

The yield on the 10-year Treasury note closed at 5.2% on June 13, down from the 5.25% close on Tuesday, June 12, the highest level since July, 2006. But this was up substantially from the 4.89% seen on May 31 and the 4.63% yield recorded on April 30.

We believe investors are becoming increasingly convinced the anticipated U.S. economic slowdown may have already occurred in the first quarter of this year. During that period, the economy expanded by only 0.6%. However, growth is likely to accelerate in the coming quarters, and investors are concerned inflation will resurface and force the Fed to delay its rate-cutting program until the first quarter of 2008. Also, we believe foreign investors have been withdrawing funds from intermediate-term Treasuries in search of better yields outside the U.S. This is after the European Central Bank (ECB) hiked rates to 4% (which was expected) and then indicated they are not finished (which was not expected).

Where do we see the 10-year yield headed? David Wyss, Standard & Poor's chief economist, projects the yield on the 10-year note will close the year at 5.22%, peak at 5.27% in the second quarter, and end next year at 5.25%. Not only does he think core inflation is under control, he reminds us the personal consumption expenditures (PCE) deflator is up only 2% from last April, and now sits atop the Fed's "inflation comfort zone."

Although other central banks are pushing the Fed to raise interest rates, Wyss believes domestic issues will negate the international pressure. He now expects the Fed to postpone a rate cut until early 2008, since the unemployment rate remains low. He thinks an upside inflation surprise could lead the Fed to raise interest rates before then.

Mark Arbeter, S&P's chief technical strategist, believes yields will retreat from the 5.25% level in the near term. Following a pullback, he sees yields advancing to a range of 5.40% to 5.50%.

Based on either forecast, S&P expects yields to hold or head higher from these levels over the intermediate to longer term, which could lead to a slowdown in global M&A and corporate earnings growth. This year through June 13, global announced and completed M&A transactions rose to $2.06 trillion, 54% higher than the $1.34 trillion recorded during the same period in 2006, according to S&P's Capital IQ. Yet this growth rate is down from the 67% year-to-date outperformance recorded through mid-May. As a result, we believe higher global interest rates are already having a negative effect on M&A volume.

As of June 11, S&P equity analysts were still projecting a 7.3% increase in 2007 operating earnings for the S&P 500. S&P's Investment Policy Committee is maintaining its year-end 2007 S&P 500 target of 1510 because of the risk of higher interest rates and the potential for slowing earnings growth. This factored into S&P Equity Strategy's decision to reduce the recommendation on financials (XLF) to markeweight from overweight and on utilities (XLU) to underweight from marketweight. We recommend overweighting the S&P 500 consumer staples (XLP) and health care (XLV) sectors, and, in addition to utilities, we advise underweighting the consumer discretionary (XLY) and materials (XLB) sectors.

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