By James Mackintosh
There are lots of reasons for investors to worry about the effect of politics on the markets in 2017. One thing they probably don't need to worry about is that rising bond yields on their own will trash share prices.
It's true that bond yields have risen fast as prices tumble. Since the summer, those holding the 10-year Treasury have lost 9%, the fifth-biggest loss over such a period since 1980. The benchmark 10-year yield of 2.55% is the highest in two years after hitting a record low in the summer. Together with the Federal Reserve's hike last week and the stronger dollar, it's tightening financial conditions sharply.
Shares have been unruffled by the upset in the bond market, with the S&P 500 up 6% since bond yields started to rise in July. Far from being a problem, rising bond yields have been a symptom of improving expectations for the economy, the very same hopes that pushed up shares.
The Trump reflation optimism has gone a long way, and I doubt that the new president can deliver as much as investors expect when he takes office next year.
But this isn't a concern about rising bond yields as such. Indeed, if Mr. Trump fails quickly to push big tax cuts or spending plans through, bond yields are likely to drop, along with shares. The same should be expected if the economy once again proves weaker than the bulls expect.
So, the first reason shareholders shouldn't worry about rising bond yields is that they are expressing the very same underlying thought as share prices.
There are two other reasons. The first is that bond yields were exceptionally low, indeed the lowest ever. Not just the lowest since the Bloomberg terminal price series began; Bank of England research suggests interest rates were the lowest in 5,000 years.
Yields were low in large part because inflation was expected to be low, pretty much forever. Shares didn't like such low inflation, because it raised the risk of deflation, the shareholders' nemesis. A little inflation is thus accepted as A Good Thing, and a little inflation is all anyone expects. For the moment, investors aren't even pricing in inflation reaching the Fed's 2% target for the five years starting in five years' time (remember: the Fed looks at a different measure of inflation to the rest of us).
Significantly higher inflation expectations would surely hurt shares, but remain a long way off.
The second, linked, reason not to worry about bonds is that the market's been hoping for growth, not merely inflation. It's true that inflation expectations are up a lot, but the rise is mainly due to higher real yields, measured by Treasury inflation-protected securities, or TIPS. From a negative yield in the summer, 10-year TIPS now pay 0.7 percentage point above inflation, about where they started the year. Higher real yields show investor confidence of more growth, and growth helps earnings and share prices.
None of this is to claim that higher Treasury yields have no effect on the world. They clearly hamper parts of the economy, making mortgages and student loans more expensive. They hurt indebted emerging markets, too, because dollar debt becomes harder to repay as the greenback rises. An EM blowup or a U.S. economic slowdown would drag bond yields and share prices back down again.
There is one scenario where bond yields keep rising and shares fall, and 1994 provided a painful example. Of the five worst bond losses since 1980, 1994 was the only time shares also fell. The cause was a suddenly hawkish Fed, which jacked up rates that year from 3% to 5.5%, shocking investors. Even then, shares lost less than bonds.
If the Fed ditches two decades of dovish policy, watch out. Otherwise, stick to worrying about the economy and politics, not rising bond yields.
Write to James Mackintosh at James.Mackintosh@wsj.com
(END) Dow Jones Newswires
December 19, 2016 11:12 ET (16:12 GMT)
Copyright (c) 2016 Dow Jones & Company, Inc.