What does the rise in treasury yields mean for US stocks?

While Trump may have pumped up stock markets with his tax reforms, we are now seeing an increased focus on treasury yields as a driver of market volatility. What is driving this rise in yields, and why does that matter for financial markets?

Federal Reserve
Source: Bloomberg

Equity traders have been paying particular attention to the bond market of late, with a sharp rise in US treasury yields helping drive global indices lower at the beginning of February. The rise of treasury yields has seen the 10-year note rise sharply into the 3% region, representing the highest level since 2013. This is rooted in a number of factors, with the economic boom seen across the US and eurozone one such factor. As economic risk falls, investors see less need to hold super-safe assets such as treasuries, which typically hold little risk but little reward. This lack of demand causes yields to rise, making them more attractive over time.

However, more important is the rise in inflation, with yields rising alongside inflation and inflation expectations. As we see inflation rise, bonds/treasuries must also rise to be worthwhile as any sort of investment. If inflation rose and treasury yields didn’t, no one would invest as the real rate of return would be negative over time. This rise in yields poses a significant problem to stock markets. One of the main sources of funding over the past five years has been due to the fact that, quite frankly, there are few places to park money that gave any reasonable rate of return. With interest rates at rock bottom, treasury yields diminished by historical standards and assets such as gold losing value in three of the last four years, it comes as no surprise that investors have looked towards stocks as a means to grow wealth.

However, with higher inflation comes interest in all three of those. Rising inflation forces central banks to act, with the recent rise in US interest rates driving higher savings rates for consumers. Inflation also raises treasury yields, as they become less attractive at lower rates of return. Finally, with rising rates comes a higher risk, driving interest in safe-havens such as gold, which finally managed to post a positive year once the Federal Reserve (Fed) started raising rates at a relatively notable rate (three hikes in 2017).

This shift in attractiveness elsewhere means that stocks are no longer the only game in town, and with higher inflation comes a greater likeliness that investors will spread their assets more widely. Not long ago, stocks only needed to provide you with a dividend to beat the competition, yet with alternatives coming to the fore, we are seeing the bar elevated gradually for stocks.

While stocks will still remain the investment of choice for most, this relationship between inflation, interest rates, bond yields and stocks is worth watching as a potential driver of market volatility going forward. With President Donald Trump’s tax reforms passed, we are seeing increased interest in the role of treasuries as a driver of market sentiment.

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