Why rising US bond yields really matter for markets

Before I get started this morning, a date for your diaries we're holding an event in central London on the evening of 13 November.

I'll be sitting down with MoneyWeek regular David Stevenson, and Charlotte Ransom of digital wealth manager Netwealth to talk about "How to survive the next bear market" (always a timely topic, but particularly so right now, I feel).

It should be a good night with plenty of time to talk to the panelists I always enjoy meeting MoneyWeek readers so if you can come along, I'd love to see you there.

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And now, speaking of bear markets, these rising bond yields that everyone's talking about don't look great for global stocks.

Rising US interest rates affect every other part of the market

The market's eyes are on US bond yields right now. Why do these matter so much?

Let's keep it simple. You can pick holes in all of the following statements if you really want to, but at the level at which we're talking right now, it's not going to help you understand the world any better.

The US is the world's most important economy; the US dollar is the world's most important currency; and the interest rates at which the US government can borrow over a given period (which is what the yield on US bonds represents), are the world's most important interest rates.

You know that if you lend money to the US government, you're going to get it back. You may not get it back in dollars that are worth the same as the ones you lent them in the first place (that's what inflation can do to your money), but the US government is not going to default on you. In the jargon, these bonds carry no "credit risk".

So it's the global "risk-free" rate. What does that mean?

Well, if you can put your money into a bank account, say, and earn an annual risk-free return of 3%, then what does that suggest for the return you'll demand from other assets?

That's right. In order to be tempted to take a risk with your money, you will have to be convinced that you can earn more than 3% a year from your investment.

If you're investing in something only a little more risky, then you won't need much more than 3%. But if you're investing in something a lot more risky, like small-cap stocks or junk bonds, then you'll need a good bit more than 3%. So if that risk-free rate rises, it should push up the expected returns demanded by investors on all other assets.

If you expect to get a bigger return from an asset, then there are really only two ways for that to happen.

Firstly, your expectations can change. Maybe you think that the economy is so strong that corporate earnings are going to rocket and so you become willing to pay more for a stock today, because you think its prospects have improved. (This is why rising rates don't always have to be bad news at first if the economy is growing strongly too, that can offset it.)

Secondly, and more bearishly, your expectations may stay the same, but the price can drop. Eventually, the price will get to a point where you reckon the asset is now worth buying, despite the rising "risk-free" rate.

Thing is, that can often be quite a way below the current price, because once people get it into their head that asset prices need to sell off, they usually get a lot cheaper, before they hit the "buying point" again.

Tech stocks look particularly wobbly

So which assets are most vulnerable? Arguably, it's the assets that have been most dependent on a very low "discount rate" for their valuations.

Here's an example: tech stocks. Tech stocks are growth stocks. They're all about the "jam tomorrow".

When the world is operating on a very low discount rate (ie, when interest rates are very low), then jam today doesn't really look much more valuable than jam tomorrow. So if a tech stock is promising to build a virtual monopoly that will mean tomorrow's jam is effectively infinite in supply, you'll be willing to pay an awful lot for that.

But once rates start rising, so does scepticism. You start to worry about all the slip-ups that could happen between today and tomorrow, that could prevent the company from delivering all that jam. So you're not willing to pay as much for the promise.

This is one reason why tech stocks slid so hard last week. Of course, there's also the fact that they've benefited from many other things that are also now reversing rapidly. For example, relatively free global trade has enabled the creation of complex supply chains based on cheap labour and the ability of goods to cross borders easily and inexpensively. The burgeoning trade battle between China and the US is set to change all that.

And that's before you even begin to consider the fallout from the suggestion that China has put "spy" chips into bits of computer equipment destined for the US.

What's my point? Take a look at your portfolio and take stock of the assets that look expensive and that appear to be pricing in a lot of optimism. Also take a look at those that have been neglected and grown undervalued because people have got over-excited about the "jam tomorrow" stocks. Think about rebalancing taking some of the profits you made on the popular stuff and putting it into the less popular stuff.

I'll get into more specifics in future editions of Money Morning as this all unfolds.

Oh, and don't forget to check out the details of our upcoming event!

PS. On bond yields and risk free rates, I know what some of you are thinking: you're thinking, if the US ten-year Treasury yields 3.2%, and it's the global risk-free rate, then how come Japanese government bonds can get away with yielding 0.1-ish% and Italian bonds are still getting away with only a little more than 3.5%?

There are some technical explanations involving currency differences. But it's also to do with two other key influences: central banks and inflation. Both Japan and Europe are continuing to do quantitative easing, so their bond yields are artificially low few things are as risk-free as having a guaranteed price-insensitive buyer for your country's debt. But Japan and Europe also currently have lower inflation than the US. So when you're getting 3% in the US, that's not 3% in "real" terms once you account for inflation it's more like 1%.