- Stocks and the 10-year Treasury yield have historically moved in the same direction when the yield has been below 5% as it is currently.
- Stocks have mostly interpreted rising interest rates as a signal of better economic growth, rather than harmful inflation, and have historically risen during periods of rising rates.
- We believe the bull market in stocks can coexist with the bear market in bonds.
Surging bond yields have not spooked stock market investors. The latest sharp move higher in bond yields has caused stock market investors to ask the question, At what point do higher interest rates potentially begin to hurt stock prices? It is logical to think higher interest rates will eventually slow the economy. Borrowing costs rise and higher inflation—which has accompanied higher interest rates in the past—erodes purchasing power. These are all reasonable points to make when evaluating the relationship between stocks and bond yields. Here we look at this relationship and make the case that, given the still low rate environment, rising interest rates do not put the aging bull market at risk.
IS 5% A MAGIC NUMBER?
The 10-year Treasury yield has risen about 110 basis points (1.10%) over the past five months to 2.46%. That move in rates has certainly not spooked the stock market, as the S&P 500 is up 130 points, or 6.1%, during that period and 4.2% during the fourth quarter alone.
One of the reasons stocks have done well as bond yields rose is that the absolute level of yields is still low. We see in Figure 1 that, at a 10-year yield of 5%, the correlation between stocks and bond yields has historically changed. When the 10-year yield has been above 5%, as it was throughout the 1970s and 1980s, stocks tended to move in the opposite direction of bond yields (so when rates rose, stocks fell, i.e., negative correlation). Conversely, over much of the past two decades, the yield on the 10-year Treasury has been below 5%, and stocks and bond yields have exhibited positive correlation (stocks have tended to rise as bond yields have risen).
This relationship suggests that, with the 10-year yield currently near 2.5% and well below the 5% mark, rising bond yields may not disrupt the stock market’s ascent. So, while we would certainly not consider 5% a magic number, we do think yields have room to move before they become worrisome for the stock market.
We believe the change in the stock-bond yield relationship reflects the different growth and inflation signals reflected by the high and low levels of interest rates. Starting from low yield levels, rising interest rates tend to reflect rising economic growth expectations and ebbing deflation fears. And bond market losses may make investors sell bonds to buy stocks.
Conversely, at high interest rate levels, economic growth has been accompanied by high inflation, which can negatively impact economic growth and erode the present value of future earnings, a negative for stock prices such as was observed in the late 1970s.
The negative impact of high inflation on stocks is evident in Figure 2, which shows the stock valuations have historically been lower at high levels of inflation, as measured by annual changes in the consumer price index (CPI). The latest reading on the CPI (October 2016) is below 2% (1.6% year over year), which has corresponded to average price-to-earnings (PE) ratio of just over 18, which happens to be where the S&P 500 PE is currently.