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The surging run higher in bond yields has definitely gotten markets buzzing this past week. In that lieu, one of the more common market themes is that higher bond yields tend to be bad for stocks. In recent days, that certainly looks to be true.
When Treasury yields pushed up earlier this week, with 10-year yields hitting 4.81% (the highest since October 2023), equities came under pressure with both growth and tech shares buckling lower.
Typically, markets have come to know that higher Treasury yields tend to create a tougher environment for equities. But why exactly?
The simple theory is that investors can earn a higher return from relatively safe government bonds, which then raises the hurdle rate for owning riskier assets such as stocks. And with higher yields, it also increases the discount rate on future corporate earnings. So, that tends to hit long-duration growth stocks especially hard and is a key reason why tech shares also struggle when real yields move up significantly.
However, I would argue that not every rise in bond yields sends the same message to broader markets.
If bond yields are rising because economic growth is improving, that also means that corporate earnings are strengthening and investors can feel more positive about the outlook. In turn, that can also lead equities to perform modestly as stronger earnings may outweigh the drag from higher discount rates.
The problem today is that the rise in bond yields is not quite that.
As mentioned here, it’s all about renewed inflation expectations and a term premium driven by increasing fiscal risks instead. And that is a much less comfortable combination for equities.
Higher inflation-related yields can squeeze equity valuations without providing the offsetting benefit of stronger corporate earnings growth. And when you throw in rising energy costs into the equation, suddenly company margins can also come under pressure.
As yields pull back a little from the highs since yesterday, that is perhaps why stocks are finding a bit-part relief for the moment. That alongside the softer ADP employment data, which reduces some pressure on the Fed outlook to tighten policy this month.
But still, there is one more major hurdle to get through this week. And that will be the US jobs report tomorrow.
A softer non-farm payrolls print could push bond yields lower by reducing expectations for another Fed rate hike, which would likely provide further support for equities. All else being equal, that will be the sort of relief that investors are hoping for to end the week.
Even if there is a catch that too weak a labour market report may present growth worries, that is not the main focus right now.
That being said, if this relief does come, will it all just be temporary though?
At this juncture, the ideal scenario for equities is probably not simply “lower bond yields”. One can argue that it perhaps needs to be a case of “lower bond yields for the right reason”. That being inflation pressues cooling, the Fed becoming less restrictive on policy, and economic growth remaining resilient.
That as the bond market is saying something quite different about the economy and how that may impact corporate earnings especially.
Taking that into consideration, the real problem for stocks isn’t just about higher bond yields. The reason(s) why may be the scarier thing.
This article was written by Justin Low at investinglive.com.
