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There was a lot of red in the markets today.
The Nasdaq dropped 3.5% and the 10-year Treasury completely smashed through the 1.5% threshold rising higher than any previous point in the last year.
Exactly what is happening this week and why is any of this happening?
Here’s the thing. There’s been a tremendous sell-off for US government bonds and that’s having a widespread effect on the rest of the markets. Share prices are plummeting and the ever expanding tech stocks are facing the worst of it.
Today, we witnessed the bond market seeing a huge volume of sells. The price of bonds in turn started plummeting. As the value of bond’s decreases, the interest rate or yield on those bonds increase. In other words, prices and yields move inversely to each other.
This might sound confusing but let’s take a look at an example. Let’s say we buy a bond for $100 that pays us $3 each year. In this case we are getting a 3% yield on our bond each year(3/100 = 3%). Now imagine if our bond’s value decreases to $50, we’ll still be getting paid $3 but now we’re netting a 6% yield(3/50 = 6%).
Unfortunately, as the price of bonds fall due to lack of demand or any other reasons, the yield on bonds increases. During this last week, the demand for bonds was so low it caused the price to decrease to a point low enough to create enough demand for people to buy them.
In turn, the 10-year treasury yields have jumped up past the 1.5% threshold which is generally seen as the limit before the equities markets feel the pain and share prices crash. When we see the historical data and the yield consistently increasing over time, investors begin feeling very scared.
Historical data for the 10-Yr Treasury Yield; Source: Marketwatch.com
As the overall market starts feeling the nerves, we see big red days like today. The tech-heavy Nasdaq led the losses dropping 3.5% and the S&P 500 not too far behind losing 2.5%.
Why Higher Bond Yields Mean Lower Stock Prices
Historically we see higher Treasury rates in times of economic growth or recovery. In this week’s case, the market is scared of interest rates increasing due to inflation rather than an economic boom. In general, higher interest rates put a lot of downward pressure on equities prices for two major reasons.
Firstly, as the yield’s increase, investors might turn to bonds for lower risk when their interest rates increase.
The second reason is directly tied to cost of capital. When interest rates increase, it makes it more expensive to borrow money. This hurts companies that are growing rapidly and it even hurts consumers that want to take out loans for a house or education.
This is why we see the Nasdaq and huge tech stocks take the large share of the losses today. As it gets more expensive for them to borrow money, growth stocks have less capital to keep growing. We commonly see lower corporate profits and plummeting share prices.
Despite the large losses incurred today, this might not be all bad news. Over the last year, the stock market has seen one of its quickest recoveries from a bear market since the 1990’s.
This just goes to show how willing the government is to step in in order to keep the lights on. Experiencing this, the markets fully believe and are in fact predicting another flood of stimulus dropping from Congress in order to further stimulate economic growth. In fact, we may have reached a point where future stimulus waves are taken for granted and already priced into the market.
On the other hand, the speedy increase in Treasury yields have taken many by surprise and have now forced many institutional and retail investors to reassess their own risk tolerances. This has a big effect on the market’s predictions and opened the possibility of rates being brought back up much earlier than anyone would have expected.
A Silver Lining in the Market’s Bloodbath Today
Seeing the market reacting like this can be daunting to many investors but it can also be seen by some as a huge opportunity. When the market sells off so quickly there can sometimes be an emotional factor at play which causes an over-correction.
If you’re bullish on a specific sector or company, all the red today might just be a huge discount and entry point into a new position or expanding a previous one.
“Buy the dip.”
This article is for informational purposes; only not all information will be accurate. This should not be considered Financial or Legal Advice. Consult a financial professional before making any significant financial decisions.