Why Wall Street’s growth-heavy Nasdaq Composite is still rallying as Treasury yields rise

Technology stocks continued to outperform in the past week even though hotter-than-expected U.S. inflation reports and strong retail-sales data have pushed up expectations for how much higher the Federal Reserve will need to raise borrowing costs to prevent price pressures from strengthening. Traders of Fed-funds futures priced a growing chance of a half-percentage-point rate hike from the central bank in March, which would take the policy rate to between 5% and 5.25%, according to the CME FedWatch Tool.

See: Stock-market bulls defiant as bond market surrenders to Fed. Here’s what to watch.

The correlation between the Nasdaq and the Treasury yields was negative in 2022 as tech and growth stocks tend to be more sensitive to interest-rate expectations. When bond yields rise, investors may see more value in fixed income debt because future cash flows and growth in corporate profit will be discounted by higher interest rates, making technology stocks less appealing to investors compared to bonds with soaring yields. 

The question then is why Nasdaq is still rallying and outperforming the rest of the stock indexes despite rising Treasury yields and hawkish Federal Reserve expectations. The rate on 6-month Treasury bills
TMUBMUSD06M,
5.026%
rose above 5% for the first time since 2007 on Tuesday. The yield on the 2-year Treasury note
TMUBMUSD02Y,
4.629%
was 4.621% on Friday, after hitting its highest level since November on Wednesday. Bond prices and yields move inversely. 

“Rising real yields were a massive headwind for technology in 2022, but sensitivity has fallen to zero in 2023,” wrote Huw Roberts, head of analytics of Quant Insight in London, in a Wednesday note. “Viewing the Nasdaq as a function of bond yields alone is akin to reading an old script.”

“This thing about narratives is completely understandable, but sometimes the market will take existing narratives as gospel, as truisms, and the interest rates and growth stocks and technology stocks is a classic example, and it will be right more often than not, but it’s not set in stone,” Roberts said in a follow-up interview with MarketWatch.

“Looking at two factors side by side doesn’t really do justice to something as complex and intertwined as macro, you need to break it all apart and look at the independent relationship.”

Quant Insight’s model which measures the independent relationship between the Nasdaq and a flurry of macro indicators such as the Atlanta Fed GDPNow tracker, copper prices, credit spreads, and currencies shows that Nasdaq is becoming less correlated to real yields, but more to economic fundamentals like economic growth data and bond credit spreads.

“That’s the regime shift, the changing story that happened. And that’s why our model is saying ignore real yields for now. That’s not what’s driving the Nasdaq. It’s the real economy,” Roberts said. 

See: ‘Underlying bullish tenor’: U.S. stocks fare surprisingly well as Treasury yields rise after hotter-than-expected inflation, says Morgan Stanley’s Andrew Slimmon

Equity-market investors are reassessing the U.S. economic trajectory for the second half of 2023 and 2024 and probably anticipating much slower growth, said Arun Bharath, chief investment officer of Bel Air Investment Advisors.

“If that’s the case, then this should be some push for growth stocks over value stocks,” Bharath told MarketWatch via phone. “I think the equity market is looking ahead and thinking growth is going to be slow and therefore growth stocks will come back especially when interest rates start going up and maybe come down in 2024.” 

Another explanation is that many growth stocks, which have a healthy non-U.S. exposure, may take advantage of the depreciation of the U.S. dollar this year.

“Think about revenue exposure of some of these stocks, with China coming back online and everything else and money market growth for the first time looking better than developed market growth in many years. If you believe the dollar is peaking, or other is already peaked and maybe declining over the coming quarters, that should be positive for non-U.S. revenues and earnings,” Bharath said. 

The ICE U.S. Dollar Index
DXY,
+0.02%,
a measure of the currency against a basket of six major rivals, jumped to its highest level since early January on Friday after falling from its 20-year high reached in September. 

Nasdaq Composite finished the week slightly higher on Friday, gaining 0.6% after booking three-day win streak earlier this week. The S&P 500
SPX,
-0.28%
lost 0.3% and the Dow Jones Industrial Average
DJIA,
+0.39%
booked a weekly loss of 0.1%.