Why rising US treasury bond yields are the achilles heel of global stock marketsPosted on 09 January 2014 with no comments from readers
The cornerstone of market valuations around the world is the interest rate paid on the 10-year US treasury bond, the bedrock of global finance. The Federal Reserve has promised to keep interest rates low for as long as it takes to fully revive the US economy. But it has done no such thing.
Since last May the interest rate paid on T-bonds has shot up from 1.7 to close to three per cent. US mortgage rates have followed. Bond prices move in the opposite direction to interest rates or yields as they are known, so the US bond market, the largest liquid pool of finance in the world has crashed by almost half in value.
Bonds vs. equities
As if those losses are not bad enough the higher yield on bonds ought also to be dragging equity prices down. Why? Because bonds compete with equities for investors and when bonds pay higher yields then share prices have to fall in order to increase the dividend payout per share.
Why then has this not happened? US stocks have continued to rise while bond markets have been falling. That’s simply because investors came out of a falling bond market and into a rising stock market. However, such upward momentum has its limits and the valuation rule will always triumph in the end.
For if bonds offer a better return than stocks to investors then money will start to flow back into bonds and away from equities. Market experts think 3.15-3.25 per cent yields are the tipping point.
If that proves correct it is only a recognition of the investment arbitrage: bonds have become cheap and stocks look expensive by comparison. Once Wall Street rolls over the stock markets of the whole world will follow.
Shanghai no surprise
The Shanghai Composite is already there, having lost 60 per cent of its value over the past four years but then local interest rates have jumped ahead of the rest of the world. Is this where US stock markets are going next?
China was the first economy to go for massive stimulus in the global financial crisis and the first to experience high inflation and higher interest rates. Central banks have a long record of overdoing these things. Getting it just right is very rare.
Standby for a rough time in global financial markets as they adjust to the reality of higher US interest rates which means lower stock markets.