10-4 Good Buddy

HIGHLIGHTS:

• A 10-year Treasury at 4 percent means bond rates are back near decade highs and could represent a buying opportunity for investors looking for fixed income assets.
• "Higher for longer" could impact parts of the equity market in different, or more dramatic, ways.
• Navigating a tough landing will be difficult for the Fed as it needs consumers to hold steady while other economic news weakens, otherwise a recession is likely.
• Europe is seeing higher-than-expected inflation in some countries, while bond markets reprice ECB's terminal rate and stock markets remain volatile.

The 10-year Treasury yield has inched back up to around the 4 percent mark. It's something we haven't seen since last October, when the benchmark rate reached a decade-long high of 4.24 percent. The strength and resiliency of the US economy and consumers have investors concerned that inflation may be more entrenched than recently thought. Worries stemming from the January jobs report and other economic data have pushed rates up a half-percent across much of the curve. Financial markets have been in a good-news-is-bad-news cycle, and that remains true, as the Fed may need to aim even higher with rates. We are seeing a similar picture in Europe as Germany had an unexpected inflation increase and investors are pricing in a 4 percent rate from the European Central Bank. Meanwhile, the Fed's own expectations—as evidenced by its dot plot—show a median estimate of 5.1 percent for this year. However, market predictions for an even higher terminal rate have gained momentum.

What does that mean for investors? The most recent rate moves are giving investors another bite at the apple when it comes to fixed income allocations in portfolios. The recent surge along the yield curve is providing investors with a buying opportunity in bonds if consumer prices can be reined in relatively soon. Inflation at 2 percent and a 10-year Treasury at 4 percent gives a decent cushion for real return, and that safe-haven holding would be beneficial if we see an economic slowdown. Currently, Bloomberg Economic Forecasts show a recession probability of 60 percent.

A higher terminal rate for longer will also be detrimental to equity markets as borrowing costs increase and corporations try to protect margins in the face of price inflation and possible wage inflation. The benchmark rate increase has an exponential effect on valuations. For example, a 50-basis-point move up could mean up to a 10 percent decrease in valuations, depending upon the company, per Bloomberg. Earnings reports are starting to show this weakness as margins have compressed and year-over-year declines have rippled across the fourth-quarter earnings season.

That said, we aren't counting equities out yet despite the cold water pouring onto the market. There are opportunities for stocks to move higher through the end of the year, particularly in select sectors and industries. Higher rates will affect higher growth areas of the market more dramatically—so beware. On the other hand, infrastructure investment and the Inflation Reduction Act will supply fiscal support for many areas of the market, including energy and industrials, and we all know how quickly the Fed can shift gears. In addition, strong consumption should provide revenue support for corporations; if inflation metrics start to decrease, margins could get a boost heading into next year.

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