Bond yields are rising. Since bottoming in July 2016, 10-year bond yields have risen by around 150 basis points in the US. In Australia, 10-year yields reached a bottom in August that same year and have since risen by around 100 basis points. Equities have since risen by 9.5% in Australia and by 30% in the US. Valuation theory tells us higher bond yields are supposed to be bad for equities, all else equal. But all is not equal.
It is true that over the long term, equity prices and bond yields have exhibited a negative correlation. Since 1962, there has been a -10% correlation (on a rolling 3-year basis) between monthly changes in US equities and US 10-year bond yields (Chart 1). That is, a rise in bond yields is associated with a decline in the monthly return on equities.
But this relationship has been incredibly unstable and very volatile through time. It has been as high as +74% in 2012 and as low as -62% in 1990. The relationship has been mostly negative between 1966 and 2001 (-31%) but has been positive since (+33%). Interestingly, the best year for US equities was 2013 when the asset class returned 30%. Over the same year, bond yields rose from a near record low of 1.8% to 3%.
Chart 1: Shifting correlations between US equities and bonds
Is there a level for bond yields to watch out for?
The level of interest rates may play a role here. Prior to the turn of the century, 10-year bond yields in the US averaged 7.5%. Since 2001, the yield has been half that, averaging just 3.3%. Similarly in Australia, 10-year bond yields averaged 9.9% prior to 2001 and 4.6% since.
The correlation between equities and bond yields turned decisively positive in 2001. This was around the time that US 10-year yields fell below 5%. Looking at the distribution of monthly equity returns for different levels of bond yields we can see where the sweet spot is (Table 1). In the falling bond yield environment equities showed positive monthly returns right up until yields reached the 4-5% mark in both Australia and the US. As yields moved below this level equity returns began to turn negative. In the rising rate environment, as we are in today, equities show positive average returns up until yields hit the 6-7% mark in the US and 7% in Australia. Of course, the probability of a negative return rises as yields rise (Chart 2). Historically, the probability reaches 40% at yields in the 5-6% range in the US and in the 6-7% range for 10-year yields in Australia.
Chart 2: Testier times at higher yield levels
What matters more - inflation or growth?
Whether rising yields are good or bad for equities may also depend on what is driving the move up - is it inflation or is it a rise in real yields reflecting higher potential growth in the economy?
Between 2001 and the end of 2007, equities had a positive correlation with both components with the magnitude similar in size. Over this period, the biggest driver in bond yields was the movement in the real rate associated with changes in the potential growth of the economy.
Generally higher potential growth is associated with higher inflation - certainly that was the case prior to the Global Financial Crisis (GFC). If long-term earnings growth tracks nominal GDP growth, then a gradual rise in yields associated with higher growth and inflation may not be bad for equities.
In the 10 years since the GFC however, the correlation with the real yield turned negative (Chart 3) and the magnitude of the correlation with inflation doubled. In the "lower for longer" post GFC environment, higher growth has not been associated with higher inflation. In this environment, a rise in interest rates associated with a rise in potential growth compresses corporate margins given the absence of pricing power.
In the post crisis environment, what matters most are signs that the economy is healing. This is evidenced best by a rise in inflation. Higher inflation suggests central banks have been successful in steering their economies out of the post-GFC-induced deflation funk. The rise in strength of the correlation between equities and inflation possibly reflects how important inflation and pricing power is to corporate earnings.
So rising yields may not necessarily be all that bad for equities providing that the level remains relatively low and the move up is driven more by inflation than real growth. Intuitively, the best type of inflation for equities is demand-pull as cost-push inflation tends to be absorbed in profit margins.
Chart 3: The post-GFC new normal