An intense week with a second war raging in Israel which adds to the uncertainty swirling around the financial markets. Will this war be quick? Will it draw in more countries? Will it be drawn out as in the Ukraine? The government of Israel declared war so this is not a conflict or a skirmish and means there will be lasting consequences for their borders. For U.S. politicians they will again be considering financial aide to a foreign country while running massive federal deficits which means interest rates will push higher unless there is a reckoning to the spending.
Treasure Issuance Continues
The nexus from the federal budget to the financial markets is when the Treasury Department auctions bonds. Unfortunately, we had three this week and none of them went well. The strong dollar also creates an incentive for foreign holders to sell as a hedge to their currencies weakening so their participation is waning.
You can see in the above chart that foreign purchases of Treasuries is not keeping up with the elevated issuance. This means interest rates have to rise to clear the auctions. Also, the Federal Reserve is not participating in these auctions as their quantitative tightening policy means they are not re-investing as bonds on their balance sheet mature. You can see their Treasury holdings in the chart below and they have a long way to go before returning to pre-pandemic levels. No-bid at the auctions will continue.
Corporate Bond Yields
The contagion effects of raising interest this fast has yet to be reflected in corporate earnings. You can see on the graphic to the right that high yield companies are issuing debt near 10% and the weakest credits are closer to 15%. For some of these companies, they will have a solvency issue unless they raise equity capital.
Investment grade bonds are getting closer to 6% as the 10Yr continues to push higher but those companies have stronger balance sheets and will need to adjust their spending based on their cost of capital. Lots of changes are in the pipeline.
10Yr Treasury Yields
The uptrend in 10-year yields is undeniable and should continue into next year. For the mean time, bond prices are oversold so odds are we see lower yields in the coming sessions with overhead resistance at 5.05%.
The S&P 500
Multiples typically contract when interest rates rise and we have yet to see that reflected in stock prices this year. We will get a slew of earnings reports in the next three weeks so we will get an update if these valuations are justified. Price action this week was slightly higher but has remained in this area for the past three weeks. Generally, we need to see prices above $450 to confirm a bottom has formed and if earnings reports disappoint then we may see a larger downtrend unfurl.
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Paul J McCarthy III CFA
President, Kisco Capital