Whether you’re only now peaking out from behind the sofa or you’ve been investing passively like a trooper and refusing to look at your portfolio until Boxing Day, if you’re reading this site you’ve probably seen headlines implicating US bond yields in the recent assault and battery on the stock market.
For example:
- Surging yields raise threat of tipping point for stocks – Wall Street Journal
- Here’s why stock-market investors suddenly freaked out over rising bond yields – MarketWatch
- Treasury yields are increasing again, reigniting concerns about higher rates in financial markets – CNBC
Are pundits in this game of financial Cluedo right to finger Mr Treasury Bond in the trading den with a cudgel as the villain?
As always – who knows. There are plenty of dodgy-looking drifters riding around stock market town at the moment and occasionally firing their guns into the air, from geopolitical tensions and rising oil prices to high valuations in the US and its trade spat with China.
Any of those other factors – and more, or perhaps nothing specific at all – could have been the trigger for what wasn’t a particularly large correction anyway, especially in America.
Investing nerds like me still debate what caused the huge 1987 crash. We can’t expect a definitive answer to what’s so far been a run of the mill wobble.
Higher rate hate
All that said, I suspect sharply rising Treasury yields are probably having an impact in various ways on the market.
In particular, the commentary from US central bankers that there may be several more rises to come seems to be vexing in some quarters.
Many of the same commentators and traders who chastised the US Federal Reserve for a decade for suppressing rates to record lows now seem happy to put the boot in again when rates are rising.
Given markets move on sentiment in the short-term, this sound and fury can make a difference.
The obvious question is why do rate rises matter, anyway?
After all, a US 10-year government bond is still only yielding a little over 3%. For almost all the post-World War 2 period, that would have been considered bargain basement.
Also, why should UK investors care? We’ve seen a couple of rate rises here, but our yields are still much lower than in the US.
Isn’t everything bigger in America? Why not the yield on the 10-year Treasury bond?
Alas, contrary to some wishful thinking in recent years, we do not live on a financial island in splendid isolation. Warren Buffett calls US government bond yields the gravity of financial markets, and we almost invariably feel the impact here of major developments there.
For example, the relative attractiveness of putting money in a US bank instead of a UK or European bank can move both our bond markets and our currency, by influencing the behaviour of massive and rootless capital flows. Money tends to go to where it’s treated best.
As for rising yields themselves, I’ve had a few queries about this both here and in the archetypal pub.
I’m certainly not a bond expert or a stock market historian – some of our readers are far more knowledgeable about the mechanics of the yield curve than me!
Nevertheless I did make a fair fist of explaining the potential issues arising from the prolonged low interest rate era back in late 2016.
It seemed to me then that Central Banks were ready to start closing the spigots on super-easy money. Politicians, too. I mused that they feared that the core business model of banking risked becoming unprofitable, with unpredictable knock-on affects.
I’m not sure that’s proven out, but the rate rises have certainly started, at least in the US and UK.1
On the down low
Bond yields rising off the floor may matter to traders and analysts long before they are seen in costlier mortgages or over-indebted ‘zombie’ companies going bust.
As I wrote in my long piece:
A discounted cash flow model puts a discount on the future cash due. This reflects the uncertainty about future profits, as well as inflation and interest rates.
Normally, distant payouts are deeply discounted. But with the risk-free rate so low that doesn’t happen so much.
Why does this matter?
Because uncertain future forecasts have grown in importance compared to near-term cash flows. A discount rate of 2% doesn’t have much impact until you get far out.
This makes the present value of an asset even harder than usual to determine with confidence. Because future cash flows assume greater importance, the valuation is based on more finger-in-the-air guesswork.
It’s a nerdy-sounding but important point that may mean market valuations are wildly off. Even a modest rise in rates could cause a crash in all sorts of assets beyond what we’d expect.
I’ve heard a couple of people ask why technology shares that pay no dividend fell the most in last week’s kerfuffle.
Nobody owns those for income. Surely it should be utilities or ‘dividend stalwarts’ like Unilever and Johnson and Johnson that should be most marked down, if nervous investors believe they can now get the regular cashflows they require from bonds again?
That makes sense, and I do think the relative attractiveness of dividend-paying companies compared to government bonds will shift over time if rates keep rising.
But it’s the change in the discount rate that explains the theoretical shift in the valuation you’d put on say an ASOS or an Amazon, or even a Fevertree. The companies may rapidly start looking more expensive in an analyst’s model, even if nothing has changed in the business itself.2
Anyway, rather than rehash that article again here I’d suggest rereading those two previous pieces for more on how low yields may have distorted things in the past decade. Unwinding such distortions, where they exist, seems bound to have some impact.
Here are the links:
Also, if you tend to read Monevator via email or you don’t check back on the comments much, you will have missed the long thread that followed the latest Weekend Reading.
If you are feeling blue after a kicking that – incredibly enough – at one point had the FTSE 100 back at 1999 levels, you might at least find some comradeship in the thoughts of fellow readers.
(Thanks again for sharing all!)
- The Federal Reserve further announced in late 2017 that it was beginning to reverse QE – what it calls ‘Policy Normalization’. [↩]
- The more prosaic reason they fell farthest is that people dump pricey growth shares in times of panic! [↩]
The problem with all the historical rules regarding bond yields and dividend yields, is that odd things happen over time.
For many years we got used to bond yields being substantially higher than dividend yields, typically 2 to 1, we knew that in the dim and distant past that it had been the other way round and of course we have had the last decade or so with just such a situation of dividend yields being substantially higher than bond yields…
It’s hard to be confident that higher bond yields mean higher dividend yields, because that does not always reflect the more recent past, perhaps bond yields will sail past dividend yields ?
@Hari — Agreed, rules work in the markets until they don’t. That said, my point in the previous two articles I linked to was not so much that due to some agreed precedent we can now expect this or that to happen. It’s more that we don’t know exactly what will happen because near-zero rates across most of the world are unprecedented (the first article includes the famous Bank of England graph from a few years ago showing that rates were at their lowest for an estimated 5,000 years! 🙂 )
Perhaps we can think of it as like starting an old car that has been left in a garage unused for ten years. Eventually it might run again like any other car would, but there’ll probably be some engine knocking, bangs, gurgles, and general juddering along the way!
Why should bond yields and equity dividend yield be compared at all?
Bond yield is fixed income whereas dividends are part of total return.
@Marco — Hi, I mentioned dividends in the article because we’ve heard a lot of talk — and seen some evidence — over the past decade of determined income seekers moving along the risk curve into equities as yields fell on various grades of bonds. I agree dividends are but one component of total return (even if you’re looking only at cash returned to investors one should probably consider shareholder yield, which includes buy backs).
The relationship between bond yields and the total return expectations implied by a discounted cash flow analysis concerns the risk-free rate from high quality government bonds as an alternative investment option – and what expected compensation an investor demands for taking their chances with a company’s shares instead. 🙂
Arrgh… things like that “FTSE100 back at 1999 levels” drive me bananas. I’m sure I’m preaching to the choir here but I’ll carry on anyway: If you’d put say £10K in accumulation units of an FTSE100 index tracker (or reinvested divis) back in 1999 then you’d have something like £20-£22K now (figure from eyeballing trustnet charting; depends how low you got charges) thanks to the tasty 3.5%+ yield and compounding. Unfortunately these “it’s back to where it was years ago” soundbites are the sort of thing which really (I’ve heard them cited by an investment-averse relative) do contribute to the uninformed thinking they’re better off sticking with whatever miserable rate they can get from cash savings. A shame it’s not the “total return” index number which is reported by default (then the news would be no more shocking than “we’re back where we were in early 2017” I think).
@Tim — You’re right of course about dividends, and I’ve often pointed it out myself. But the fact remains that the FTSE 100 price index that we all use is back to 1999 levels – and over a shorter period since the early 1980s when it launched until 1999 it went up seven-fold! (*cough* Without dividends *cough*) The fact that it is still stuck here nearly 20 years later is meaningful, even if it’s not the whole picture.
The German DAX index is a total return index, but all the other major ones I can think of are not. So as things stand, when talking about indices we can either include an obligatory waffle about dividends every time you cite one of them, or you can, er, just cite them like everyone else.
(I don’t think your point is wrong or even unwelcome to be clear. 🙂 But it’s not as if I wrote “The last 19 years have been for nothing” or anything like that. Very aware of the importance of reinvested dividends. You’ll like the graph third from the bottom on this article, for instance! http://monevator.com/too-big-to-scale-understanding-long-term-stock-market-returns-and-graphs/)
A price index is probably handy for people in retirement, as many plan to draw the “natural yield”, or at least to behave in a roughly similar fashion. The total return index would be relevant to accumulators.
Should either be corrected for inflation? (I accept that it would be madness to try to allow for tax, and probably even for charges.) Frexample, in inflation-corrected terms how far down is the FTSE from its peak in 1999? If you allow for both inflation and divis, how has it done?
@Tim – and if you had stuck the £10k in 1999 into the average savings account, you would have about £19k by now. This compares to your £20k in the FTSE with dividends reinvested. The tasty 3.5% does not look so tasty now does it? A huge amount of risk in the FTSE100 for pretty much the same return as a very low risk savings account.
It’s not always helpful to show the ftse same as it was on the last day of 1999 as I imagine very few people invested at the market peak and the returns from day 2003 or 2009 would look pretty good …also equally unhelpful !
If one has been investing on a regular saving basis over a period of time you’d have done pretty good.
Other indexes are available !
I think a rise in long-dated real bond yields would eventually be a problem for most risky asset classes. There are solid reasons for the rally over the last decade (we came from very cheap valuation levels in 2009), but it’s not as though global productivity and growth have been shooting the lights out. I find it easy to believe that lower long-term risk-free rates PV’ed upfront a substantial amount of gains. A reversal of that could be painful. The 30-year discount factor at 3% is 0.41, at 4% 0.31, a 25% reduction in PV.
The other issue is that rising long-dated yields may drive correlations to higher levels. I noticed today that all 15 assets in a risk-parity index I look at were in the red over the prior 24 hours, for only the 12th time in the last 16 years. So much for diversification. Of course nobody complains when every asset is rallying but it might not feel as much fun when they all fall.
Indeed! About the only thing I’ve (casually) noticed having any strength in the past couple of weeks is gold — and that’s strength in the way that a very weedy movie character who has disappointed his allies for the previous 90 minutes is able to summon the gumption to open the spaceship door under fire or some other similarly underwhelming heroism. 😉
Rising bond yields (/falling bond prices) allied to falling share prices has always looked likely to be a component of the unwinding of this bull market, but I still have some hope that it might not be too severe, at least outside of the US. Albeit partly because global markets ex-US have been much weaker performers! But also because, as yet, there’s still no great sign of inflationary pressures that should cause rates to really soar.
@TI: Yes I’m certainly not accusing this site of peddling “The last 19 years have been for nothing” sentiments! It’s more when it gets reported in mass media with no other context or qualifiers that the message can get distorted (or transformed into what people want to hear to vindicate their own decisions, in the case of my risk-averse ).
Interesting to learn that the DAX is total return. A quick google suggests it’s had a fairly constant 2.8% yield so divis a not insignificant part of the returns. Wonder if anyone has ever researched the impact on the psychology of German investors? Looking at the DAX chart vs the FTSE100 for last 20 years, if you don’t know about the difference the DAX looks like it’s been the better ride with less “setbacks”. In fact I see the Telegraph had an article “How Germany’s stock market gives a false impression that it beats Britain’s” a couple of years ago!
@RetiredinLondon that’s an excellent point thanks. I was somewhat incredulous but checking vs historic savings rate data at http://www.swanlowpark.co.uk/savings-interest-annual I do indeed get a ~£19K figure. Wonder if/when we’ll ever see 5% on cash again…