• The new headline this week centered on the 10-year U.S. Treasury yield, which rose slightly above 3% intraday for the first time since January 2014. The 10-year U.S. Treasury is a yardstick used to gauge long-term growth and inflation expectations and thus serves as a key indicator of where the U.S. economy is heading.
• The markets, which have been lethargic, sold off as they digested the news on concerns that higher interest rates could start eating into corporate profits and potentially signal more inflation.
• There is little debate that the economic expansion is classified as "late-cycle," but that does not mean it must come to an early end. With the passage of the Tax Cuts and Jobs Act late last year, growth could accelerate throughout 2018, suggesting the end is not upon us just yet.

Is there a significance  to 3%?

The 3% yield is viewed as a key threshold for many reasons, two of which could have a meaningful impact on the economy. First, auto loans, home mortgages, and other loans are tied to the benchmark 10-year yield. Mortgage rates in particular are closely tied to the level of the 10-year yield: as the 10-year yield rises, mortgage costs will move higher. As mortgage costs rise, U.S. economic growth, which is primarily fueled by credit, could slow down. Second, investors fear that higher interest rates could start to eat into corporate profits and signal that more inflation is coming. If corporate profits slow, that could result in layoffs, stagnant growth, a potential recession, and lower stock prices.

In many ways, the move up in yield is a positive sign indicating a normalization of markets as we enter a late-stage economic growth cycle. Nevertheless, investors have become accustomed to extremely low rates and are likely to panic when they see psychological thresholds breached. According to FactSet, corporate earnings have been strong so far for the first quarter, with 17% of the companies in the S&P 500 reporting actual results, of which 80% of those companies reported positive earnings per share (EPS) and 72% reported positive sales. Unfortunately, investors seem to be shrugging off the strong corporate earnings news over a single data point. Relatively speaking, a 3% long-term yield is not very high, and is an indication that central banks are stepping back because markets are healthy, and can cope without central bank help.

  

Bottom Line

As we move further into the 10th year of the current economic cycle, it is understandable that investors are nervous, especially as monetary policy and financial conditions shift from lowering interest rates to raising interest rates. There is little debate that the economic expansion is classified as "late-cycle," but that does not mean it must come to an early end. With the passage of the Tax Cuts and Jobs Act, growth could accelerate throughout 2018, suggesting the end is not upon us just yet. Moreover, investors should consider that consumers did not begin feeling the effects of tax cuts until the middle of February, when companies adjusted wages to reflect the new tax rates, suggesting that consumption could pick up for the remainder of the year. In addition, a very strong first-quarter earnings season suggests companies could increase investment spending in the quarters ahead. Taken together, these effects should sustain both economic and earnings growth in 2018, providing support for equity markets. So far, the 3% shock does not appear to be enough to alter the upward economic momentum that began last year with the tax reform. For the moment, at least, the beat goes on. La de da de de, la de da de da.

This material is for informational purposes only and sets forth the views and opinions of our investment managers as of this date. The comments, opinions and estimates are based on or derived from publicly available information from sources that we believe to be reliable. This commentary is not intended as investment advice or an investment recommendation nor should it be construed as a solicitation to buy or sell securities. All indexes are unmanaged, and an individual cannot invest directly in an index. Index returns do not include fees or expenses. Past performance is no indication of future performance. The Standard & Poor's 500, often abbreviated as the S&P 500, or just the S&P, is an American stock market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ.

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