The Market Is Right to Be Spooked by Rising Bond Yields

On Oct 3, 2021

No one likes losing money, but Tuesday’s stock-price fall worries me more than the headline of a 2% fall in the S&P 500 should. In itself, 2% is no biggie: three days this year had bigger falls, and on average we have had seven worse days a year since 1964.

What bothers me is that the rise in bond yields that triggered the fall was really quite small, and there could easily be a lot more to come. The 10-year Treasury yield rose only 0.05 percentage point, taking it above 1.5%, and the 30-year rose slightly more to just above 2%. If this is the sort of response we should expect, then get out your tin hat. Yields need to rise four times as much just to get back to where they were in March.

Why, you might reasonably ask, are stocks suddenly spooked by bond yields? In the boom up to March, stocks and yields marched higher together, and for the past two decades higher yields have generally been better for stocks. The difference is that investors see the central banks turning hawkish, even as economic growth slows, because they can’t ignore high inflation.

Pascal Blanqué,

chief investment officer at French fund manager Amundi, puts it, the fear is of a rise in rates driven by inflation alone pushing central banks to act, rather than a rise in rates driven by economic growth pushing central banks around. This is the mind-set that dominated investment until the late 1990s. If it sticks, it marks a profound change.

In the long run, it would mean bonds would no longer provide a cushion when stock prices drop, making portfolios more volatile. In the short term, if the sharp rise in yields since the Federal Reserve meeting last week is the start of a trend, then shares are in trouble. On the flip side, if yields come back down, it might be good for stocks—as it was on Friday—rather than bad, as has usually been the case for a couple of decades.

To see the threat, think back to the spring, when yields were marching higher. The outlook for inflation is about the same (investors are pricing it as high but temporary). The outlook for economic growth is worse, which provides less support for stocks generally. But central banks have shifted stance from super-easy for pretty much forever to start talking about tightening.

This is the wrong sort of rise in bond yields. When yields were rising up to their March high of 1.75% for the 10-year Treasury, stocks were on a tear because yields were being driven up by the prospect of higher economic growth, and so stronger profits. Beaten-up value stocks and economically-sensitive sectors soared, while Big Tech and other growth stocks, plus the reliable earners known as quality stocks, went sideways. After March, falling yields boosted growth and quality stocks again, while value and cyclicals went sideways.

This time, stocks are reacting as they do when yields rise…