Whether the stock market is going up, down, or sideways, there is always a reason to worry about it. Psychologists call this the negativity bias that keeps us hooked on bad news and the media, including the financial media, knows it.

Last week, a new reason was found in the quick spike in bond yields, with the US 10-Year Treasury bond yield increasing from 1.05% to 1.61% in just over a week. A 7-year treasury auction also faced weak demand.

The theories behind why bond yields increasing are bad for stocks are:

1. The discount rate for equities increases – put another way, as bond yields increase, the gap with what stocks are yielding narrows, so equities will fall
2. Inflation is coming – bond investors are demanding more nominal yield to compensate for it
3. There’s a liquidity problem in the markets

However, the Federal Reserve isn’t too worried. Neither are we. We look at the evidence and the logic for this.

Firstly, the evidence seems to point to stock markets going UP, not down, in periods of rising bond yields.

Source: Ben Carlson, awealthofcommonsense.com, 21 Feb 2021

This may be because the same underlying economic forces that cause bond yields to rise can also cause companie and therefore their stocks to do better in aggregate. Bond yields generally inform us about investors’ confidence about the economy. When investor confidence is high, prices for the 10-year treasury bond drops and yields rise. This is because investors feel they can find higher returning investments elsewhere – namely, in equities – and do not feel they need to play it safe. The discount rate effect can thus be cancelled out by the whole rising tide.

That is why the Federal Reserve remains cool about the bond yield movements. Better-than-expected corporate earnings, falling case counts, and other positive news surrounding vaccine development all point to economic growth of a rising tide.

That is not to say that stocks cannot decline after bond yields reach a certain level – they have in some of the cases in the table above (in others they went up some more) – but we just can’t tell what the magic trigger level is. In any case, we know the markets recovered even from these downturns and continued to go up over the long term. In addition, for now, the absolute levels of bond yields are still at a historical low, and it is the low base that amplifies the degree of change.

On inflation, the theory is that when inflation is high, purchasing power declines, revenues and profits of companies go down, so stocks should go down. The signs of inflationary pressure, especially a tight labour market, aren’t strong. In fact, some moderate inflation is to be desired as it usually means better demand.

As for liquidity, well, the Fed won’t worry about something under its control. The Fed has made it clear it would remain accommodative on this front.

If you have been following our long-standing investment philosophy, you would be aware that trying to time the market based on short-term signals is a bad idea. At a minimum, you can’t time the market all the time. Here’s a reminder about the last time we advised against making portfolio changes based on short-term bond yield. When the US Treasury Yield curve inverted during March 2019, many people were concerned that it was signaling an incoming recession. What actually happened was that the S&P500 returned approximately 30% in 2019, making it the best stock market year since 2013! However, if they had sold their positions then, they would have missed out on the huge positive returns in that year and the impact of missing those returns on a compounded basis for a long-term investor would have been significant.

So this time, once again, we wouldn’t bet against history and logic (and the Fed). Stay invested in the portfolio with the asset allocation we have advised as appropriate to your need, ability and willingness to take risk, to capture long-term market return; in which we use market-based funds.