Stocks fell on Tuesday by the most in three weeks as the 10-year Treasury yield rose to its highest level since July 2011.
The sell-off in stocks and increase in yields accelerated in the morning after data on retail sales in April came in in-line with expectations while prior months’ results were revised higher, indicating U.S. consumer spending will likely bounce back in the second quarter after a tepid start to the year.
“As things stand, consumption growth is on track for a big rebound in the second quarter, which should push overall GDP growth up to more than 3% annualized,” said Michael Pearce, senior U.S. economist at Capital Economics. “That will keep the Fed on track to raise rates again at its June meeting.”
On the economic calendar on Wednesday, markets will get April data on housing starts and building permits, which are both expected to decline compared to the prior month, as well as the April industrial production data from the Federal Reserve.
Earnings out of Macy’s will be closely watched after the first quarter was something of a disappointment for consumer spending as personal consumption grew just 1.1% to start the year, though Tuesday’s data on retail sales indicates better times ahead for retailers.
Why rates keep moving higher
On Tuesday, the 10-year Treasury yield hit its highest level since 2011.
The push to get rates up to a new multi-year high came in the form of April’s data on U.S. retail sales, which bolstered the case for a strong second quarter of growth and three more rate hikes this year from the Federal Reserve.
But the read that rates are being simply driven by a stronger economy and a more aggressive Fed are but one part of what Deutsche Bank’s Torsten Sløk sees as a three-part attack pushing rates higher.
Because certainly the U.S. economic cycle — which features a central bank raising rates, a tight labor market, strong consumption, rising oil prices, and new tariffs on imports — points towards a more inflationary environment. All else equal this will push interest rates and bond yields higher as investors demand to be compensated for taking a fixed return amid an inflationary environment.
Sløk, however, also cites higher hedging costs for foreign investors who had been such a big buyer of Treasuries in recent years as putting pressure on yields.
One of the stealth stories in financial markets over the last year has been the decline in the value of the U.S. dollar.
Amid the decline in oil prices that was seen in late 2014 through 2015, the dollar gained about 30% against other major currencies through the end of 2016. This made dollar-denominated assets like Treasuries more attractive and less expensive to hedge.
As the dollar’s value has declined, however, hedging out the currency risk for a foreign investor buying Treasuries has become more expensive. Buying Treasuries has thus become less attractive, and a relative decline in demand makes the price of Treasuries fall, sending yields higher.
Sløk’s third factor pushing yields higher is the increased supply of Treasuries being sold this year. The Trump tax cuts passed last year pushed likely Treasury issuance for 2018 to around $1.3 trillion, the most in at least eight years.
The dynamic here is simple — more supply of an asset without a resulting increase in demand for that asset causes its price to go down. And when bond prices decline, yields rise.
So the story in markets on Tuesday was stocks falling as yields rise after a strong economic data report. This isn’t entirely wrong.
But this narrative does leave out that a weaker dollar and more Treasury issuance have put pressure on rates in the U.S. this year. Where the dollar goes from here, of course, will change how much rates are pressured by a currency-sensitive buyer. And no one really knows where that will be.
But more U.S. debt issuance from the Treasury Department is a certainty over the coming months and years. Meaning that the pressure U.S. fiscal policy puts on U.S. borrowing costs is unlikely to change in the years ahead.
Myles Udland is a writer at Yahoo Finance. Follow him on Twitter @MylesUdland