The S&P 500 is having its worst session in months after Fitch Ratings downgraded the 'AAA' U.S. credit rating to 'AA+', citing rising deficits and "the erosion of governance." Essentially, Fitch doubts that Washington functions well enough to get the country's fiscal house in order.
S&P 500, Nasdaq Fall
The 10-year Treasury yield jumped to its highest level in nearly nine months, before paring gains as stock prices weakened further. The rising Treasury yields mean higher rates for auto loans and mortgages, with the 30-year fixed-rate mortgage back around 7%. All things equal, a higher 10-year Treasury yield also implies lower equity valuations, particularly for growth stocks, based on analysts' models that discount future earnings back to the present based on the 10-year Treasury yield.
That helps explain why the Nasdaq is leading the market lower in Wednesday stock market action, down 2.2% vs. a 1.4% loss for the S&P 500 and 1% for the Dow Jones.
Volatility has returned just as Fed chair Jerome Powell began to sound dovish about disinflation progress and a potential end to rate hikes. The latest upsurge in the 10-year Treasury yield has forced stock market bulls to pull in their horns a bit, stalling the S&P 500 rally. But that may be the best thing for the long-term health of the bull market.
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Economic Slowdown Needed
The sooner the economy slows in a pronounced way, the faster inflation will recede and put behind the biggest risk for the S&P 500 — a firming of inflation pressures that leads to further rate hikes that choke off growth more aggressively.
Right now, it seems like the economy could go either way. Growth surprised on the upside in Q2 as real GDP rose 2.5%, up from 2% in Q1, as stronger business fixed investment offset softer consumption. Equity gains, strength in nonresidential construction and an AI investment boom could keep the economy striding forward. Or maybe the resumption of student loan payments will further slow consumption as high borrowing costs hit small business hiring.
The latest rise in long-term Treasury yields increases the chances of a period of subpar growth that brings down inflation to a level the Fed can live with, while modestly raising unemployment and setting up the next stage of the bull market.
Fed Rate Hike Odds Slip
As of Wednesday afternoon, odds of another quarter-point rate hike at the next Fed meeting on Sept. 20 eased to 17.5% from around 25% a week ago. Odds of the next hike coming by the following meeting on Nov. 1 dipped to about 33% from 35%.
Markets are sensing that higher long-term yields will help avert the need for still-higher short-term yields.
Why Is The 10-Year Treasury Yield Rising?
The 10-year Treasury yield rose as high as 4.13% on Wednesday, before pulling back to 4.08%, still up from Tuesday's close of 4.05%.
The 10-year yield had pulled back to around 3.75% as recently as July 20, before making a sustained move higher.
Though the Fitch downgrade has grabbed headlines, it's at most a bit player in the upsurge in the 10-year Treasury yield.
For now, Wall Street largely sees eye-to-eye with Treasury Secretary Janet Yellen, who downplayed the Fitch downgrade, saying, "Treasury securities remain the world's preeminent safe and liquid asset."
"The downgrade is unlikely to trigger any large selling of Treasuries or a fundamental shift in investor behaviors," wrote Deutsche Bank fixed income strategist Steven Zeng.
JPMorgan CEO Jamie Dimon called the U.S. credit rating downgrade "ridiculous," but added that it "doesn't really matter."
One reason is that investors already lived through a U.S. debt downgrade by S&P Global Ratings in 2011, with little effect. In fact, Treasury yields tumbled in the aftermath.
To be sure, there are fiscal challenges coming down the pike as military spending rises along with the cost of caring for an aging population. Republicans want to focus spending cuts on the other 25% of the budget, while Democrats prefer tax hikes. But that battle, including over expiration of key Trump tax cuts at the end of 2025, will need to be wrestled with after the 2024 election.
Why Is the 10-Year Treasury Yield Rising?
Several things have conspired to push up yields, despite better news on the inflation front. On Wednesday, payroll processor ADP estimated that private employers added a stronger-than-expected 324,000 jobs in July vs. forecasts of 185,000. However, ADP doesn't have a great record of predicting the Labor Department's monthly jobs report, which is out Friday. Wall Street economists expect employer payrolls to rise by 200,000, with a 175,000 gain in the private sector.
Economists also cite a recent decision by the Bank of Japan to allow the yield on 10-year Japanese government bonds to exceed 0.5%. The market for Treasuries is global in nature, so a higher floor for Japanese yields has an impact on other government debt. For example, the higher Japanese bond yield makes higher U.S. Treasury yields less of a draw, potentially reducing inflows from Japan.
On Monday, the U.S. Treasury surprised Wall Street by announcing its plan to issue $1 trillion in debt via public markets in the third quarter. The borrowing estimate was $274 billion higher than announced in May. Deutsche Bank's Zeng wrote that the higher borrowing stems from a rise in deficits as the government has to pay more interest on the debt.
Even as the government is selling more debt, the Federal Reserve continues to unload Treasury and mortgage securities purchased during the pandemic, shrinking its balance sheet by up to $95 billion per month.
Government Shutdown Coming?
Potential for further increases in the 10-year Treasury yield appear limited. For one, Wall Street still expects inflation to come down enough for the Fed to start cutting interest rates by mid-2024.
UBS is predicting that the 10-year Treasury yield will fall to 2.75% by June 2024.
Long before then, a government shutdown, which analysts see as increasingly likely, could weigh on the U.S. economy and Treasury yields.
House Speaker Kevin McCarthy managed to win enough bipartisan support to pass the deal to lift the debt ceiling in June, and that deal included spending levels for fiscal 2024. But House Republicans are determined to spend less than levels agreed to in the Fiscal Responsibility Act. The House bills also include add-ons related to abortion, contraception and other issues that make Senate passage unlikely.
Plus, there won't be much time to reach agreement with the Senate before funding expires on Oct. 1 after the House returns from its August break on Sept. 12.
