The 10-year Treasury Yield Briefly Touches 2% As Bonds Selloff In Premarket Trading

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(Thursday Market Open) Equity index futures were mixed on Thursday ahead of the Consumer Price Index (CPI) despite Wednesday’s broad market rally. It has been light week for economic news but heavy on earnings announcements. However, traders looking for excitement may get it today thanks to a hotter-than-expected CPI report.

The report showed that inflation grew 0.6% month-over-month, above the expected 0.5%. It also grew at 7.5% year-over-year which was also above the forecasted 7.3%. Economists were hoping for some easing in inflation, but these are the hottest number since February of 1982.

The bond market reacted severely in premarket, trading with the 2-year Treasury yield—that tries to anticipate the federal funds rate—jumping up to 1.45%; the 10-year Treasury yield (TNX) rallied and briefly touched 2% in premarket trading. The bond market increased the probability of a half-point rate hike by the Federal Reserve in March to above 51%. Additionally, the yield curve as measured by the 2s10s flattened by dropping to 0.55.

Equity index futures fell on the news the with S&P 500 futures dropping 0.85% immediately after the news in premarket trading. The Nasdaq 100 futures fell 1.35%, and the Russell 2000 futures traded 1.33% lower. The Dow Jones Industrial Average futures fell the least at 0.43% which could signal a potential flight to quality. The Cboe Market Volatility Index (TNX) rose just 7% which could be a good sign that the initial reaction may not have staying power.

Before the CPI report, Twitter (NYSE: TWTR) rose more than 5% in premarket trading despite missing on earnings. The company reported that it netted 6 million daily active users in the fourth quarter. It also reported that Apple’s (NASDAQ: AAPL) iOS privacy changes have only had a “modest” impact; Twitter was able to achieve a 13% increase year-over-year in monetizable daily active users. TWTR plans to buyback $4 billion in stock.  

The biggest earnings mover may be Mattel’s (NASDAQ: MAT) which rose 10.77% in premarket trading on much better-than-expected earnings. CEO Ynon Kreiz said the company’s turnaround is now complete after destroying its earnings estimates. MAT reported earnings of 53 cents per share while analysts were forecasting 30 cents per share. The company was able to wrestle away Disney’s (NYSE: DIS) princess line away from competitor Hasbro (NASDAQ: HAS) and add it to its Barbie line—a big driver in the company’s success.

The soda wars rage on as Coca-Cola (NYSE: KO) and PepsiCo (NASDAQ: PEP) both reported earnings and both beat on top- and bottom-line numbers. KO had the bigger beat at four cents above estimates while PEP beat by one cent. The bigger beat by Coca-Cola is translating into bigger premarket gains with stock rising 1% while PepsiCo is up 0.39%. However, PEP tried to sweeten the pot by increasing its dividend 7% and announcing a $10 billion stock buyback program.  

From soda wars to streaming wars, Disney (DIS) stunned investors by adding 11.8 million subscribers to its Disney+ streaming service, well above analysts’ estimates of 8.3 million. The gain adds a little more confusion into who might be the winner of the streaming wars.

Drug maker AstraZeneca (LON: AZN) also reported higher-than-expected earnings and revenue, boosted by its COVID-19 vaccine sales. The company increased its revenue outlook but warned that the Covid-related sales would likely decline. AZN was up 2.6% in premarket trading.   

A day after CEO Lynn Good met with other utility companies at the White House with President Joe Biden, her company Duke Energy (NYSE: DUK) reported better-than-expected earnings. In her interview with CNBC, Ms. Good said the company is looking to make investments to shore up the power grid and to meet the demand for the increase in electric vehicles. DUK rose 0.36% in premarket trading.

In Anticipation

On Wednesday, the day we could possibly coin as “CPI Eve”, equity markets saw widespread increases. The Nasdaq Composite ($COMP) was up 2.08%, while the S&P 500 (SPX) climbed 1.45%. Even the frequently underperforming small caps were not left behind as the Russell 2000 Index (RUT) gained 1.86%. The gains spread across various sectors as well. The communication services sector was up 2.45% largely because of a 5.37% gain in Meta Platforms (FB), which finally showed some buyers stepping in after its precipitous post-earnings fall. Two of the sectors, which underperformed Wednesday, were consumer staples and utilities, which are more defensive in nature and often underperform when the market has a strong day.

One of the most notable individual movers on Wednesday was CVS Health Corp. (CVS), which fell 5.45%. The company forecasted a sharp decline in the number of COVID-19 vaccines it will distribute this year.

Chipotle Mexican Grill (NYSE: CMG), on the other hand, jumped 10.16% on earnings. The restaurant chain reported both an earnings beat and a positive forecast. The company’s CEO also indicated that it has been able to increase margins even with increasing inflation and labor costs. This is a great situation for the company, as many companies have struggled to pass increased costs along to customers.

A Pair’s Skate

The ease with which Chipotle has handled inflation is not true for the entire market. Inflation is a big concern—hence, the anticipation we’ve seen concerning today’s CPI Report. The fact that there was a market expectation of an annual inflation increase of 7.2% tells you we are dealing with big inflation numbers. Regardless of whether this morning’s number came in hot or cold, such high inflation numbers need to come down. That is where the Fed comes in. Inflation numbers affect Fed policy, and Fed policy influences inflation. It is hard to talk about one without the other.

And so, the market isn’t just concerned about inflation, it is also concerned about the Fed’s response to inflation. Raising interest rates may be appropriate monetary policy, but that doesn’t mean the market as a whole will react positively. Parts of the market are more likely to get hit hard with higher inflation numbers and concomitant rate hikes. For example, information technology and consumer discretionary stocks could suffer more in this environment, while staples and financials may outperform. 

However, the issue of how sectors perform in a rising interest rate environment is a bit of an oversimplification because interest rates are not a singular thing. There are interest rates on corporate and municipal bonds as well as Treasuries. There are short-term rates, medium-term, and long-term rates, as well as other ways of parsing down interest rates. Although typically there is a correlation between the movement of these various rates, the relative movement of these rates do matter. Notably, a common measure is the difference between longer-term and shorter-term rates, or the interest rate spread.

CHART OF THE DAY: TIGHTENING. The interest rate spread between the 10-year note and the 2-year note has narrowed since its March 2021 high point. FRED® is a registered trademark of the Federal Reserve Bank of St. Louis. The Federal Reserve Bank of St. Louis does not sponsor or endorse and is not affiliated with TD Ameritrade. Data Sources: ICE, S&P Dow Jones Indices. Chart source: The thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

Lessening the Curve: So, while the 10-year Treasury Yield (TNX) has risen sharply over the past two months, the spread, or difference, between the yield on the 10-year note and the yield on the 2-year note has decreased during that same time. This is one reason why the chart of the financial sector has looked more like a roller coaster than a ski lift over the past few months, even in a rising-rate environment; Financials typically benefit from a rising, or upward sloping, yield curve. To be sure, the yield curve is far from negative, which it last was, albeit briefly in 2019. Seeing that happen would be a very concerning turn of events but an unlikely scenario in the near term.

Trading the Curve: So how should investors approach the yield curve? First, realize that an increasing yield curve is generally perceived as a positive sign for the economy. A declining yield curve is often perceived as negative. It is normal to fluctuate, so don’t overreact to every undulation, but keep an eye on the general trend.

A continued flattening of the yield curve will signal to some investors to take a more defensive posture in the market. This means investing in sectors that tend to outperform in tough market conditions. Defensive sectors include consumer staples and utilities. On the other hand, an increasing yield curve could favor financials, such as banks or insurance companies. It could also favor companies in the consumer discretionary sector or industrial sector, which do well in a strengthening economy, as indicated by the increasing yield curve.

The bottom line is that there are a lot of factors to consider in the economy that go beyond just a headline CPI number or interest rate decision. These factors must be taken as a whole so that investors don’t overreact to the market’s short-term reactions to single economic announcements.

TD Ameritrade® commentary for educational purposes only. Member SIPC.

Image sourced from Unsplash

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