Why Investors in Technology Stocks Are Paying Special Attention to Bonds

A series of central banks around the world will continue to raise interest rates this week. Market participants expect that the Fed will raise the benchmark interest rate by an additional 75 basis points this Wednesday, following last week’s unexpected and negative inflation report in the U.S. for August. This is the same amount it raised in the last two meetings in June and July and the same amount that the Swedish central bank is expected to raise its interest rates by on Tuesday.

In the same week, a 50 basis point increase in interest rates is expected from the Swiss, Norwegian, and British central banks. By increasing financing costs, central banks continue their fight against inflation with the aim of curbing the drastic rise in consumer prices.

This year’s decisions by monetary authorities have a direct impact on bond markets, which is why bond yields are rising, especially those of short-term government debt that are most sensitive to central bank decisions. Thus, the yield on the U.S. two-year Treasury bond, which was 0.8 percent at the beginning of the year, has jumped to nearly 4 percent. Besides representing the highest level since 2007, it is concerning that it is moving above the yield of the ten-year bond, which is currently around 3.5 percent, a level that has historically been a very reliable indicator of an impending recession.

Although a recession is still not a consensus among economists (according to the latest Bloomberg survey, the probability of a contraction in economic activity in the U.S. stands at 47.5 percent), there has been a correction in stock prices since the beginning of the year. Investors have enough reasons to be pessimistic about the prospects for global economic growth amid supply chain issues, geopolitical tensions following the start of the war in Ukraine, and the associated energy crisis in Europe. In such conditions, the leading U.S. stock index, S&P 500, has slid 19 percent this year.

However, persistent inflation and its impact on expectations regarding future interest rate movements, as well as new monetary conditions, are of particular importance to investors in technology stocks. The technology-oriented index Nasdaq Composite, with a decline of 27 percent this year, has recorded a significantly greater loss than the S&P 500 index. The dependence of this index’s movements over the past year on events in the bond markets is best illustrated by a graphical representation of the index’s movements in relation to the yield on U.S. Treasury bonds. For a more accurate illustration of Nasdaq’s movements with bond yields, which have been steadily rising this year, the yields on the chart are shown in reverse.

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Source: Bloomberg; FIMA-Securities

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Among the displayed charts, which compare the movement of the Nasdaq with the inverse yield of three-month, two-year, ten-year, and thirty-year U.S. Treasury bonds, the greatest correlation is visible with the yield of the ten-year bond, especially in the last three months. The last bottom of the Nasdaq, on June 17 at a level of 10,798 points, coincided with the peak yield of the ten-year bond two days earlier, on June 14, at a level of 3.48 percent.

Furthermore, the last peak of the Nasdaq on August 15 at a level of 13,128 points coincides with the last bottom of the yield of the ten-year bond two weeks earlier when it was 2.61 percent on August 1. The last failed jump of technology stocks, which was not accompanied by a drop in bond yields, is also instructive. Specifically, the Nasdaq jumped from 11,544 to 12,266 points in the first half of September while the bond yield remained stable at around 3.34 percent. The Nasdaq then lost almost all of its earlier gains in two days, and the yield continued to rise to the current 3.48 percent.

There are several reasons for this dynamic movement of technology stocks in relation to bond yields in 2022. Besides the fact that higher yields create competition for stocks as safe bond yields begin to surpass uncertain stock dividends, the increase in the risk-free rate of return affects changes in fair valuation estimates of stocks. Technology stocks, which primarily consist of growth stocks and historically carry a premium on their valuations compared to the rest of the market, are particularly sensitive to this.

Thus, changes in interest rates have a greater effect on the assessment of their fair valuation than is the case with value stocks, which trade at a discount relative to the valuation of the entire market. Additionally, market participants expect that the balance sheets of quality companies, which fall into the category of value stocks, will more easily withstand rising financing costs compared to some less profitable companies that fall into the category of growth stocks.

For all the above reasons, this week’s announcements regarding interest rate decisions are of significant interest to investors. Given that market participants currently expect the U.S. central bank to raise the benchmark interest rate by at least 75 basis points, which would raise it above 3 percent, and that it is expected to be raised to at least 4 percent by the end of the year, any change in relation to these expectations, at least in the rhetoric of Fed leaders, will certainly affect bond yields and thus almost immediately the performance of technology stocks.

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