Why Increases In US Bond Yields Hurt Your Stocks

The stock market has experienced historically high volume in recent weeks, and much of the blame has been placed on rising interest rates. The relationship between stock prices and bond yields may not be intuitive for new investors, but here’s an overview of how it typically works.

When U.S. inflation starts to rise, the Federal Reserve typically attempts to slow it down by raising interest rates. On the surface, rising interest rates and bond yields aren’t necessarily bad news for stocks, as long as the underlying economy and corporate earnings growth is still strong. Investors should remember that stocks and bonds are always in a competition for investment dollars, and investors are much more likely to choose bonds when yields are higher.

History Lesson

Since the financial crisis in 2008-2009, the stock market has been on a tear, roughly quadrupling in value. But the caveat to the big rally has been that interest rates and bond yields have been historically low throughout that entire period as part of the Federal Reserve’s effort to stimulate the economy. Part of the buying pressure in the market in recent years has simply come from investors being left with no viable alternatives to stocks. Now that interest rates and bond yields have finally started to rise in a meaningful way, investors are seeing the first bit of cash flow from the pricey stock market to the bond market, creating downward pressure and volatility in stocks.

In the near-term, it’s important to remember that the key metric that influences interest rates is inflation. With jobless claims recently dropping to a 45-year low and corporate profits on the rise, the economy is showing signs that it could be reaching full capacity, a phenomenon which tends to trigger price and wage inflation. The primary concern among investors is that the Republican tax cuts will ignite a surge in inflation that will result in the Federal Reserve having to raise interest rates at a faster pace than previously anticipated.

Latest Numbers

The Fed previously forecast three interest rate hikes in 2018, but the bond market is already pricing in an 87.5-percent chance of a rate hike in March.

In the meantime, stock prices could continue to be volatile as investors look for signs inflation growth is starting to accelerate. On Wednesday, the Labor Department reported a 0.5-percent increase in the Consumer Price Index in January, above the 0.3-percent forecast.

As a result of the uncertain picture, the SPDR S&P 500 ETF Trust SPY has dropped 3.9 percent in the past month, while the iPath S&P 500 VIX Short Term Futures TM ETN VXX skyrocketed 74.6 percent.

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