Rising U.S. Stock and Bond Yields: A Matter Worth Your Attention

After the Fed’s QE2 policies and statements about a possible QE3, the market has had difficulty digesting the impact. In December, yields on 10-year Treasury notes rose above three percent, and the DJIA continued to break high. Main Street interprets this phenomenon as rising stocks prices and bond yields. Nevertheless, rising bond yields and stock prices have been common phenomena in recent years. The phenomenon was last seen in March 2009 when QE1 was introduced. DJIA rebounded from 6544 points, and yields on 10-year Treasury notes increased from 2.5 percent to four percent. The same phenomenon occurred from April to October 2010.

However, the zero-sum game just mentioned is not entirely accepted by the market. Some state that bond yields and stock prices made new highs at different points in time. More precisely, bond yields have decreased for 30 years while stocks have been rising for 30 years. How could they both be increasing? Low bond yields increase the equity-to-bond ratio.

Based on past statistics, since 1970, the DJIA and the Hang Seng indices both move in opposite directions of bond yields. However, the calculations have some discrepancies because investors are chasing returns based on capital gains (movements in prices). If the calculation takes into account the annual changes in stock prices and the yields on 10-year Treasuries, what would the result be?

In the past 40 years, returns from the stock market do not have a direct correlation with movements in bond yields. Only the FTSE and Nikkei indices have a better correlation ratio of 0.20 (0.20 is an acceptable correlation.). If the period for calculation is 10 years, the debt-to-equity correlation ratio since 2000 is between 0.17 and 0.40. In other periods, there seems to be no correlation. Although the average correlation for FTSE and Nikkei appears to be high, the high correlation ratio was contributed by the correlation since year 2000.

Of course, one can argue that since the year 2000, the statistics are more meaningful because of acceleration in global capital movements. But it is also bold to conclude that bond yield and stock prices rose together if we make individual calculations based on bond yields.

In the figure, we use five percent and 10 percent bond yields to make our calculations. When yields rise above 10 percent, the stock market moves in the opposite direction of bond yields. Below 10 percent, the effect diminishes, and below five percent bond yields and stock markets move in the same direction, a correlation ration between 0.38 and 0.60. The average correlation has been pulled lower by numbers from 10 percent yield calculations. In addition, between the five percent and 10 percent yield, there are two important periods, from 1971 to 1979 and 1985 to 2001, where the stock market directly correlates with movements in bond yields.

Don’t ignore the possibility of rising stock and bond yields

From our analysis above, investors can profit from the stock market when bond yield increases. However, this is only true when yields are below 10 percent and more applicable when yields are below five percent. Why is that? Historically, high yields reflect inflation. But high inflation negatively impacts the stock market in two ways: firstly, high commodity prices increase business operation cost, and if it is not transferred to consumers, earning will be negatively impacted; secondly, investors demand higher dividend yields from stocks, therefore hurting the companies’ valuation. On the other hand, a fall in bond yield reflects easing inflationary pressures; corporate profit will hurt less and boost the performance of stocks. In addition, the beneficiaries of rising U.S. bond yields are foreign stock exchanges. DJIA benefits little from the increase (Correlation ratio of a mere 0.38 for yield below five percent). The proposition that bond yield and stock prices rise together cannot be held true by looking at only U.S. market statistics.

Yields on 10 U.S. Treasuries, at the current level, stand at 3.3 percent. The author expects yields to rise above four percent this year. Since the implementation of QE policies, global inflation is warming up, and rising U.S. bond yield is part of the trend. In fact, the average yield on 10-year Treasuries since 2000 is already four percent. Even before QE2 policy was implemented, yields were at a four percent high. With expected inflation, it wouldn’t be difficult to expect yields moving past four percent.

In conclusion, the correlation between bond yield and stock prices is determined by the level of the bond yield. When bond yields are above 10 percent, there is little correlation between bond yields and equity returns. However, in the past 20 years, bond yields have seen direct correlation with equity returns, and when the U.S. bond yields are at seemingly low levels, an increase in yield will result in an increase in equity returns — a phenomenon worth nothing.