Plunging bond yields boost stocks' allure ahead of Fed meeting

© Reuters. FILE PHOTO: A street sign marks Wall Street outside the New York Stock Exchange (NYSE) in New York City, where markets roiled after Russia continues to attack Ukraine, in New York, U.S., February 24, 2022. REUTERS/Caitlin Ochs

By Lewis Krauskopf and David Randall

NEW YORK (Reuters) - Whipsawed U.S. stocks have gained an unexpected ally in recent days - a historic plunge in bond yields.

U.S. government bond yields fell steeply this week, with some durations marking their biggest drops in decades, as investors bet the Federal Reserve would likely curb its aggressive rate hike trajectory to avoid exacerbating financial system stress following the failures of Silicon Valley Bank and Signature Bank (NASDAQ:SBNY).

The volatility in fixed income markets has unsettled investors, and falling yields can reflect expectations that the Fed will cut rates because of a hit to growth.

At the same time, the drop in yields has so far been a boon for equities, especially tech and other large growth stocks whose relatively strong performance helped support the benchmark S&P 500 . The index finished up 1.4% for the week, with strength in technology stocks outweighing sharp declines in bank shares.

While the banking crisis has stirred recession fears, "it's the interest rate move that's a ... tailwind for stocks right now," said Charlie McElligott, managing director of cross-asset macro strategy at Nomura.

The near-term trajectory of yields will likely hinge on next week's Federal Reserve meeting. Signs that the central bank may prioritize financial stability and slow or pause its rate increases could pull yields even lower. Conversely, yields could rebound if the Fed signals that bringing down inflation - which remains high despite a barrage of rate increases - will continue to be job one.

"The market is not quite sure how the Fed is going to look at this," said Garrett Melson, portfolio strategist at Natixis Investment Managers Solutions.

For now, futures markets indicate that investors are assigning a 60% probability of a 25 basis point rate increase at the Fed's March 21-22 meeting, with rate cuts to follow later in the year - a sharp turnaround from the hawkish expectations that prevailed earlier this month.

"For the first time during this Fed tightening cycle, the Fed now has to balance its inflation-fighting credibility with financial market stability," said Michael Arone, chief investment strategist at State Street (NYSE:STT) Global Advisors.

Treasury yields fell to historic lows after the Fed cut rates to support the economy at the beginning of the COVID-19 pandemic, fueling a stock market rally that saw the S&P 500 double from its March 2020 trough at one point.

As the Fed began tightening monetary policy a year ago to fight inflation, Treasury yields began to rise, offering investors an increasingly attractive alternative to equities. Two-year yields, which recently stood at 3.85%, hit an over 15-year high of 5.08% earlier this month.

The recent drop in rates has helped stocks regain their appeal, according to some metrics. The equity risk premium, or the extra return investors expect to receive for holding stocks over risk-free government bonds, has rebounded to where it stood in early January but still remains near its lowest level in over a decade, according to Refinitiv data.

Other metrics show stocks remain expensive by historical standards. The S&P 500 trades at 17.5 times forward earnings estimates compared to its historic average P/E of 15.6 times, according to Refinitiv Datastream.

The rally in interest-rate sensitive areas such as tech stocks appears to signal that the market expects rates to continue to fall as a widely feared recession nears, Nomura's McElligott said.

The S&P 500 information technology sector and communication services sector rose over 5% and nearly 7%, respectively, for the week, buoyed by strong gains in megacap stocks Microsoft Corp (NASDAQ:MSFT) and Google parent Alphabet (NASDAQ:GOOGL) Inc.

Some investors, however, are skeptical of stock valuations. Bob Kalman, senior portfolio manager at Miramar Capital, said the Nasdaq 100 should trade at no more than 25 times forward earnings given current interest rates, below its current 27.3.

"People have this muscle memory to buy mega-cap tech whenever they get nervous," Kalman said. "But the Fed hasn't backed off its rhetoric that they know they must overshoot because inflation is a much larger concern in the economy than a couple of bank failures."