The Bond and Stock Markets Are Unbalanced

As summer unofficially draws to a close with Labor Day behind us, Wall Street's focus remains fixed on Friday's jobs report, which presented a Goldilocks-like scenario—a labor market slowing down without plummeting into recession.

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Analysts at BMO have highlighted a notable development: the S&P 500 earnings yield, a metric measuring earnings-to-price, is now hovering just slightly above the yield of the 10-year Treasury. This observation prompts questions about the sustainability of this dynamic, especially in light of declining earnings yields compared to rising Treasury rates, and the perceived risk, even after a credit rating downgrade, associated with the full faith and credit of the U.S. economy.

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While the initial market response on Tuesday seemed to favor the scenario of falling stock prices leading to a rise in earnings yield, our call of the day comes from the team at UBS, who express a bullish sentiment toward bonds. (BMO's team shares a similar outlook, targeting the mid-August low in the 10-year yield of 3.95%.)

The UBS team, led by Mark Haefele, Chief Investment Officer for Global Wealth Management, outlines their rationale for this stance. They start by emphasizing that monetary policy, as set by the Federal Reserve under Jerome Powell's leadership, is currently restrictive. They note that real interest rates, adjusted for inflation, have turned positive, reaching levels not seen since the 2008 financial crisis. Furthermore, mortgage and credit card rates have reached multi-decade highs.

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Next, they argue that inflation is on a downward trajectory and will likely continue in that direction. Housing inflation, though not yet fully reflected in official data, is showing signs of cooling, and goods inflation recorded negative figures in July.

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The UBS team maintains that expectations regarding future interest rates have not shifted significantly. They believe that the U.S. Treasury market remains an attractive safe-haven asset and will continue to attract capital. Additionally, they highlight that there hasn't been a substantial upward repricing of expectations for the terminal policy rate, suggesting that the market perceives the Federal Reserve as nearing the conclusion of its rate-hiking cycle.

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Finally, the UBS team argues that the recent adjustments made by the Bank of Japan to its yield-curve control policy do not signal the beginning of a broader global rise in long-term interest rates. They anticipate that the changes in the yield of the 10-year Japanese government bonds will remain controlled, as the Bank of Japan places significant emphasis on maintaining financial stability.

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In conclusion, UBS identifies the most promising opportunities in the 5-to-10 duration segment within government bonds, investment-grade corporate bonds, and sustainable bonds. Their analysis suggests a favorable outlook for these segments in the coming six to twelve months.

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