For the past few weeks, much of the focus on the stock market has been around rising bond yields, specifically the 10-year Treasury note. As bond yields have risen, stock prices have slipped and investors have become increasingly sensitive to the activities of the bond market. But what does this mean for stocks? Why are bond yields rising? And why is there a correlation between the two?
Rising Bond Yields
Since the beginning of 2021, the 10-year Treasury yield has risen from 0.90% to north of 1.5% in March. There are many factors contributing to the rise of bond yields, but much of the recent activity has revolved around fears of rising inflation as the U.S. economy recovers. Additionally, significant government spending, such as the $1.9 trillion stimulus package, has further increased concerns over inflation. This fear has led to a sell off in bonds, causing the yield to rise as the price of bonds fall. But why does inflation scare debt investors? The main reason is the value of money: with inflation, future interest payments from a bond become less valuable as the value of money decreases. So when inflation expectations rise, bonds become less desirable, investors begin to sell, and their price falls.
How Yields have Impacted the Stock Market
The rise in bond yields due to a fear of rising inflation have helped initiate a market selloff in stocks. Investors fear the Fed could increase the federal fund rates from its current 0-0.25% in order to combat inflation. A rising federal funds rate would increase the cost of borrowing, putting pressure on growth stocks, which rely on cheap borrowing costs. This explains why tech stocks have been especially sensitive to the rising yields.
On March 30, the tech heavy NASDAQ dropped 14 points while the bond yields ended at 1.72%. Additionally, similar to treasury bonds, dividend-paying stocks become less attractive with rising yields. Ultimately, the most important fact for both bond and stock investors is that inflation reduces the real return of their investments. Real return is simply the return on an investment after taking into account the rate of inflation. If return on your investment is 5% but the rate of inflation is at 3%, then your real return is only 2%. For both bond and stock investors, the fear of reduced returns due to inflation can lead to a sell off of their assets, driving down both the price of stocks and bonds.
Although the rise in bond yields has caused a sell off, Chairman of The Federal Reserve Jerome Powell has stated that “as the economy reopens and hopefully picks up, we will see inflation move up” which “could create some upward pressure on price.” The Fed has stated that it will keep an eye on inflation but does not expect the move in prices to be a long term effect. According to Jeff Cox of CNBC, “expectations for core inflation moved higher, with the committee now looking for a 2.2% gain this year.” This means that the projected cost of goods, excluding energy and food, are projected to rise 2.2% over the year. The Fed has acknowledged the rising bond yields, but does not see them as a long term problem and has judged that there is no need to change monetary policy or interest rates.