US equities steal the limelight in May at expense of bonds

May has seen contrasting fortunes for bond and equity investors, with a record S&P 500 index accompanied by a sharp fall in Treasury bonds.

Stocks have rallied strongly since late March while bond yields have risen, pushing prices down, as expectations of a Federal Reserve rate cut this year have largely evaporated.

This divergence has occurred in spite of the fact that many equity investors had at the start of the year also hoped for a rate cut to help offset an expected decline in corporate earnings growth.

At the end of April, interest rate futures markets were pricing in a rate cut of 33 basis points by the end of this year, according to Banc of America Securities. Since then, the forecast has fallen to less than 10bp – representing a less than 50 per cent chance of a single 25 basis points cut this year. “It is true that equity markets would like to see an ease, but they would also as soon see the Fed stay on hold,” said Gerald Lucas, senior investment adviser at Deutsche Bank.

At mid-afternoon on Thursday, the leading US stock benchmarks were on course for a third straight month of gains. The S&P 500 index was up 3.2 per cent in May, a gain of 7.8 per cent so far this year.

The Dow Jones Industrial Average has risen even more strongly in 2007 and has set a string of record closes as investors have sought large companies with exposure to faster-growing economies outside the US.

In contrast, the Lehman Brothers US Treasury bond index was 0.9 per cent lower for May as of Wednesday.

During May, the yield on the two-year note has risen from 4.59 per cent to a high of near 4.94 per cent on Thursday. The yield on the 10-year bond rose to 4.92 per cent on Thursday, its highest level since last August.

The rise in yields has sparked flows out of bonds into stocks. Equity investors have also taken heart from a better-than-expected first-quarter earnings season and a surge in deal activity and share buybacks.

“The equity market is in a sweet spot and is able to ignore higher bond yields,” said Jim Paulsen, chief investment strategist, Wells Capital Management. He added that the market had moved from expecting an easing of rates because of a weak economy to where prospects for the economy were looking better.

Evidence of better economic prospects can be seen in the 3.6 per cent rise in the Russell 2000 index of small companies this month, said Mr Paulsen.

As traders and investors closed out their books for May, three sets of data due on Friday is likely to dictate sentiment for bonds and equities during June. Investors will closely watch the May employment, inflation and manufacturing data for clues on the trajectory of the economy as it enters the summer months.

“Stocks are not positioned for bad news on the data front,” said Jack Ablin, portfolio manager at Harris Private Bank. “We could have a rocky trading session after the employment report.” [via]