Rising rates spell trouble

The slow but steady increase in bond yields could take the shine off overpriced equity markets, says John Stepek.

This week, for the first time since late 2015, the German government had to pay interest if it wanted to borrow money over five years. Not much, mind you a mere 0.01% or so a year, still well below inflation. But it's a big change from summer 2016, when the five-year bund had a negative yield of 0.6%, meaning that markets were effectively paying the German treasury to lend it money.

It's not just Germany. Bond yields are rising everywhere, with the ten-year US Treasury yield heading above 2.72% to its highest level since 2014 (see chart). Indeed, it now looks as though summer 2016 was the bottom for bond yields. This week may have marked a significant turning point, as the world emerges from an era of chronic fear of deflation into one in which global growth is healthy and central banks are finally able to raise interest rates or at least stop printing as much money.

That sounds like good news. But this shift could come as a huge shock for investors. Bonds have been in a bull market for 35 years or so yields have been falling (and thus bond prices rising) since 1981. So most of today's investors have never coped with an environment in which long-term interest rates were rising. A bear market now could have all sorts of unexpected consequences.

Here's the basic problem. High-quality sovereign bonds (like Treasuries, gilts or bunds) represent the "risk-free rate" the minimum return you should expect to get on an investment. So if their yields go up, so should the expected yield on everything else, from corporate bonds to stocks. If markets didn't already look expensive that might not be such a problem, but they do. So the risk is that yields won't have to rise much before the shine comes off stockmarkets. Indeed, as the ZeroHedge blog notes, this time last year Goldman Sachs guessed that if US yields breached 2.75% and German bunds 0.75%, it could be "a more serious problem for equity markets". Already, stocks that are typically bought for their yields such as real estate trusts and utilities are lagging the wider market.

As long as yields rise slowly, it might not be too disruptive. The big risk is that inflation picks up, forcing bond yields higher, and driving central banks to act. Stocks would then struggle. Those with commodity exposure would be the best bet (these do well during inflation). But if we really are enjoying strong growth, inflation is the logical outcome so pay close attention to wages data this year.