Rising Bond Yield Potential Dangers

08/28/2013 12:15 pm EST

Focus: BONDS

When US bond yields rise, it can prove to be a danger to the stock market, writes David Berman in the Globe and Mail. Here he offers you some possible answers to the more concerning question, what about an even higher yield?

US bond yields are on the rise, offering a potential threat to the stock market. But if a 2.8% yield on the 10-year Treasury bond is a source of concern, what about a noticeably higher yield?

Brian Belski, the chief investment strategist at BMO Nesbitt Burns, believes the yield could rise as high as 4.5% over the next several quarters. However, he believes that higher interest rates aren't necessarily a bad thing for stocks. In fact, they could be good.

“Stock market performance is dictated by the pace of economic growth or inflation and not necessarily the level or trajectory of interest rates, in our view,” he said in a note.

He argues that investors are underestimating the resiliency of economic growth, while worries about inflation are overblown. The same goes for rising rates.

In fact, he noted higher interest rates coincide with higher-than-average stock market returns, a lower probability of negative returns and less volatility.

“Furthermore, some of the best and most consistent average returns have occurred when both nominal and real interest rates have risen from very low levels—as is currently the case,” he said.

Mr. Belski's assurances come at an uncertain time for the stock market. The S&P 500 hit a record high near the start of August, but has since slumped nearly 4%—largely over worries that the Federal Reserve's bond-buying program, known as quantitative easing or QE, will wind down later this year, removing a powerful source of stimulus for the stock market in recent years.

At the same time, bond yields have been rising sharply, albeit from exceptionally low levels. The yield on the 10-year US Treasury bond rose as high as 2.89% last week, up from just 1.63% as recently as May.

Mr. Belski acknowledges that markets have been rattled by a potential change in Fed policy—a reaction that underscores his cautious assessment this year. He has been sticking to a year-end target of 1,575 for the S&P 500, or about 4% below the current level.

But he remains enthusiastic about the US economy and the stock market over the longer-term, and sees the uptick in bond yields as “normalization.”

He analyzed the performance of the S&P 500 under various interest-rate scenarios, going back to 1953. Low interest rates aren't necessarily ideal conditions, given that they often come with sluggish economic growth. When yields are less than 6%, the S&P 500 averaged a gain of 7.4% over rolling one-year periods.

On the other hand, rising interest rates aren't necessarily bad, if the market is anticipating future economic growth. When yields are between 6% and 8%, the S&P 500 has averaged a return of 8%. And when yields are above 8%, the average return rises to 11.2%.

The trajectory of interest rates makes today's environment look even better. When bond yields are declining, after taking inflation into account, the average return for the S&P 500 is 6.2%, versus 11.2% when yields are rising. And when real yields are rising and the real rate is below average, which is the situation facing investors today, the average return is an impressive 12.1%.

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