This Has Everything to Do with Rising Rates

In case you missed the memo, 2022 has been all about rising bond yields. It’s undeniable.

We can’t talk about stocks without including a conversation about the bond market.

More specifically, the direction of bond yields. Yields are once again pushing up against their June highs, so investors must understand the correlation between the equity market and the bond market.

Higher rates do two things: They put downside pressure on the price of long-duration bonds and they act as a major headwind for growth stocks.

Let me prove it to you.

Here’s a 2-year chart of TNX (10-year yields). I’ve highlighted 2022 and the dramatic shift in yields since early January.

Rates have moved in one general direction – higher!

With that as our backdrop let’s talk about the impact of higher rates.

In the lower pane of the image above is a relative strength ratio chart comparing equally weighted value stocks (RPV) vs. equally weighted growth stocks (RPG).

In a rising interest rate environment, it’s the more value, cyclical areas of the market (Energy and Financials) that tend to outperform the growth sectors (Tech and Communications).

This is illustrated above as the line chart rises in concert with the rise in yields. The message is value stocks are outperforming growth stocks in a rising rate environment.

History has taught us that cyclical areas of the market benefit most from a rising rate environment.

It was not a coincidence, nor was it blind luck, that RWM pulled the trigger and began rotating our portfolios out of growth stocks and into value in Q4 2021.

It’s also not a coincidence that many investors that have maintained their allocation to a 60/40 stock to bonds are having one of their worst years in recent history.

It has everything to do with rising rates. Growth stocks and Bonds have sold off in unison.

Let’s dig a little deeper and zoom in on yields of the 10-year – I want to show you both sides of this relationship between price and yields.

Let’s talk for a moment about what happens as yields retreat.

Look at the chart below. You see how yields peaked in mid-June and turned lower, back to around 2.6%?

Well, what happened to stocks as Treasury yields fell?

You guessed it… the large-cap S&P 500 ripped higher! Stocks moved off their June lows, reaching a new pivot high in mid-August.

Growth stocks continued higher until rates began to reverse.

Warning: Pay attention to this correlation. It’d be foolish to say “I’m not a bond investor, I don’t care what happens to the price of bonds.”

That is a big mistake. Keeping an eye on bond yields is a great risk gauge for any investor!

Here’s a price chart of TLT, an ETF proxy for 20-year Treasuries.

As yields have climbed all year, the price of bonds, specifically TLT, has gotten smoked!

And if bond prices are falling and yields are rising, what do you think is happening to your favorite growth stocks?

Take a look for yourself: The price charts of NASDAQ (QQQ), Technology (XLK), and Communications (XLC) look very similar to TLT.

Lower highs and lower lows are, by definition, a downtrend. Please don’t buy downtrends…

And as you could guess, if the price charts look similar, so would the returns.

With Treasury bond prices down -26.72%, growth stocks are getting spanked. I think the biggest challenge right now is that yields on the 10-year are threatening new highs.

A new high in yields would suggest further underperformance out of growth on both a relative and absolute basis.

Perhaps the all-important question for growth investors, in particular, is will we see the weakest, hardest-hit areas of the market sell off even further?

The answer lies in how bonds react at these levels. If bulls can step in and repair the damage in treasuries, it would go a long way for tech, communications, and long-duration assets in general.

However, if TLT continues to slide, I’d have to imagine growth will follow.

That would also likely mean the major averages would remain under pressure due to their heavy weighting toward growth.