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How Higher Bond Yields Could Affect Equity Markets

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Higher bond yields and equity markets

The US ten-year yield has moved above the 3% rate for the first time in three years amid increased inflation (TIP) expectations and the US Federal Reserve’s resolve to continue with interest rate hikes. These rising interest rates could pose problems to the equity markets (VOO), as higher borrowing costs would shrink the profit margins for businesses that have been enjoying ultra-low interest rates for over a decade. In the same period, the S&P 500 (SPY) Index delivered a total return of over 350% in this bull-market cycle, and analysts continue to project expansion in business and thus stock prices. The question on everyone’s mind is whether stocks will continue to be attractive when bond yields are growing.

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Problem with higher rates

A higher-yielding bond (AGG) could be more attractive than a few low-return equity investments in the near term. Portfolio managers could be forced to rethink their asset allocation strategy at some point to factor in higher rates. In February, a similar sell-off involving a stock market volatility (VIX) spike and the resultant rebalancing of portfolios happened, and some large fund houses are recovering from the pain of short-volatility strategy trade.

How equity markets could be impacted by higher yields

The current equity market bull run has stretched beyond nine years on the back of additional stimulus from the US Fed in the form of low rates and abundant liquidity. Both these stimuli are on the decline now, but tax cuts and fiscal spending promises have filled the gap from these depleting stimuli. Will these new incentives continue to fuel equity market growth for months or even years?

The important factor that investors need to remember is that markets react swiftly to any perceived threat. The case of rising yields has not hit that tipping point yet, but that scenario could unfold. In the next part of this series, we’ll analyze how rising yields (BSV) are leading to higher volatility in the currency markets.

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