Bond Yields continue to rise, but what does this mean for the stock market?
Below you will see a chart of the US 10 year government bond. On Thursday it broke through its previous resistance levels to 3.11% and settled at 3.07% on Friday.
Why are Bond Yields important for the stock market?
Firstly let us remind you of what a Bond Yield is. A government bond is effectively a loan that you give to the US government (in this case for 10 years). At the end of every year you get paid a coupon (interest rate) which at the moment is 3.07% and then at the end of the 10 year period you get your capital back also. The bond can also be closed earlier than the agreed period. The Bond Yield is simply the interest rate paid on the Government Bond.
In the investment community, Government Bonds are considered Risk Free Assets. In other words, there is no chance of the US government not repaying their debt and investors are guaranteed to get their capital back as promised. This is the important part to understand that the asset is considered Risk Free. It may not mean a lot to smaller investors who are looking for bigger returns but to fund managers who are looking to beat the benchmark index S&P 500, it is significant.
The question is this, at what yield or interest rate do investors/funds rotate out of the stock market and buy the safer government bond?
For example, let’s imagine an investor/fund is faced with two choices:
1.Invest in a stock paying a dividend of 3%. The risk here is that the stock price may fall, losing capital and/or the company may also cut its dividend.
2. Buy a 10 year government bond that guarantees the capital invested plus a 3.07% yield every year for ten years.
Which investment would you pick? There is no right or wrong answer to this question because everybody is different and we all have different outlooks on the future of the stock market. If we believe that the stock market is definitely going higher then we might be more than happy to take the risk.
However, at some stage the yield on these bonds will become too attractive for investors. When bond yields reach a certain level it will cause money to flow out of riskier stocks into safer government bonds. Because the stock prices are based on the laws of supply and demand, capital outflows will lead to lower stock prices.
The current yield of 3.07% (as of May 18th 2018) on the 10 year US government bond is not enough to cause massive outflows but it will cause (in my opinion) investors to value the stock market at normalised levels as opposed to recent inflated levels. My belief is that when the 10 year Bond Yield gets above 3.5% and closer to 4%, we will see substantial outflows from the stock market.
This is something for you to start learning about…it is important. You should also do some research on the yield curve and what it means. It is the best predictor of impending recessions. The IMF are now talking of a possible recession for the US in 2020. The fact that the yield curve is starting to flatten is backing up their thesis.
This does not mean that you should exit the stock market immediately, it simply means that you need to be aware that the easy money has been made and that there are other risk factors at play.
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