“Good” Rises In Bond Yields Can Turn Bad

Just as benign dreams can sometimes turn into nightmares, a “good” rise in bond yields has the potential to become something more worrying for stock markets.

Ten-year U.S. Treasury yields have doubled in less than five months and on Thursday hit a one-year high of 1.45%. This isn’t ideal for companies as it raises their cost of borrowing and means their present cash flow is worthless to equity investors because a higher discount rate is applied. Still, equity markets can usually cope if the cause of rising yields is better economic prospects.

That’s certainly the case so far. President Joe Biden’s big fiscal stimulus plans will turbocharge a vaccine-related rebound in economic activity. A record balance of participants in Bank of America’s global fund manager survey expects to see a stronger global economy in 2021. So while stock markets have experienced some wobbles this week, the S&P 500 Index is still up 12% over the period that 10-year U.S. yields have doubled.

The Federal Reserve is also helping equity investors focus on the positive. Chair Jay Powell on Wednesday sent a clear message that tighter monetary policy, the usual party pooper of equity rallies, is some way off. He said the Fed wouldn’t raise interest rates until inflation had exceeded 2%, a situation that could take more than three years to transpire. Rate-setters may want to wait until they are certain the economy and labor market have recovered before cranking up the benchmark.

But this layers on fresh risk for equity investors. The Fed’s new policy framework means Powell wants inflation to run above 2% for a while. What’s unclear is how much of an overshoot he will tolerate, and for how long. A larger-than-anticipated rise in inflation would push bond yields sharply higher. If the rise in the cost of capital looks like it may outstrip growth rates, company valuations fall, and stock investors will have a problem.

Trouble could also come from another source. In past decades, the Fed would tap on the monetary brakes when growth started to lift prices. It may have to press on the pedal more forcefully than in the past if an inflation overshoot causes wages to rise, too, creating a feedback loop. Neither of these are immediate headaches. But stock investors may want to keep the aspirin handy.

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