Traditionally we have been told that when bond yields start to rise then stocks should fall. Well, this time around things could be different. Even as the market starts to believe that the Fed is about to embark on a period of interest rate normalisation, stocks have continued to surge higher? So, does something have to give?
At some point, rising interest rates will most likely cause stocks to fall, but in this environment owning equities when bond yields are rising could make sense for three reasons:
1) Bonds compete with equities for investors’ affections. If bond yields rise, then yield-hunters may switch out of expensive equities with low dividend yields and move into fixed income. However, due to the extraordinary period of unconventional monetary policy that we have seen, US Treasury yields are low by historical standards and are not high enough to make equity dividend yields look unattractive.
The 10-year Treasury yield, which is considered the global benchmark, is below its 12-month average at 2.54%, whereas the average 12 month dividend yield for the S&P 500 is 1.93%. Although the 10-year yield is higher than the dividend yield, bond prices are falling, while the S&P 500 has made record highs. This could keep the market interested in stocks for some time yet.
2) Putting rising bond yields into perspective: Treasury yields at 3-year highs have grabbed the headlines; however these 3-year highs are only for 2-year yields, which remain less than 0.6%. The average for the 2-year yield since 1976 has been 5.7%, more than 5% above where we are now.
The 10-year yield may be 2% higher than this, however, yields have been falling for most of 2014, and on a long-term basis even 10-year yields are extremely low. Thus, bond yields may not be high enough to tempt stock investors to get into bonds at this juncture.
3) The economic outlook: US 2-year yields are rising at a faster pace than 10-year yields. This happens when the market prices in near-term rate hikes on the back of a strong economy, with rate cuts further down the line once the economy starts to slow. When a yield curve gently slopes upwards it can be a sign of a healthy economy, which should continue to be good news for stocks, se figure 1.
As you can see above, rising Treasury yields, when put into perspective, need not be an immediate disaster for stocks, and we don’t think that the bond market will be an impediment to higher stock markets in the near term.
Figure 1: 
Source: FOREX.com and Bloomberg
Figure 2: 
Source: FOREX.com and Bloomberg
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