As 10-year Treasury yields climb, investors are fixated on 3%, a level where many fear an equity market meltdown. Yet that threshold has no fundamental relevance. Instead, investors should try to understand why yields are rising, and draw the right investment conclusions.
A common misconception is that equity prices are inversely related to bond yields. Surely, that is wrong. The Nikkei lost almost three-quarters of its value in the 1990s, a period that coincided with a plunge in Japanese government bond yields. More recently, global equities advanced strongly in the second half of 2017, along with bond yields.
No simple rule links equity and bond performance. The best framework for understanding the dynamic is the dividend discount model, which relates the equity market multiple to trend growth, the equity risk premium and the bond yield (or the “risk-free” rate). And, all else equal, this model says that the equity multiple rises if bond yields or the equity risk premium fall, or if long-term growth improves.
But all else equal is rarely correct. Changes in bond yields interact with the other drivers of share prices — the equity risk premium, the dividend yield and expectations about trend growth. So it’s complicated.
To understand the implications for equity market multiples, the first step is to determine what is driving yields up. Three possible changes could be at work: improved trend growth, higher inflation or sovereign risk.
For example, an anticipated acceleration of trend growth is surely positive for equities. It represents a durable increase in future cash flow. On the other hand, jitters about sovereign creditworthiness would undoubtedly increase uncertainty and depress equity valuations.
But the most interesting case is an increase in inflation expectations. That is particularly relevant now, insofar as rising inflation expectations are responsible for most of the acceleration in U.S. bond yields over the past six months.