• investors are worried about impact of higher interest rates on equities
  • there is now clear-cut correlation between rates and equity returns
  • impact of higher rates could depend on a broader context

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Only in the early 80’s a sharp rise in real bond yields had a clear negative impact on the S&P500. Source: Macrobond, XTB Research 

What does the chart depict?

The chart shows a relationship between a biannual change in real 10 year bond yields and a biannual price return from the S&P500. To put in a plain language we look at two year change in bond yields corrected for inflation (in basis points) and S&P500 (in % terms).

Why is it important?

A beginning of 2018 brought a noticeable increase in bond yields in United States. At one point traders started to fear that these higher rates could affect equity markets and this caused declines across the globe in February. The US 10-year bond yield is close to 3% and many investors worry that a breach of this level could renew declines on  indices such as S&P500 (US500) or DJIA (US30). 

What are the implications?

Contrary to a popular belief, there’s no strong negative correlation between higher real bond yields and S&P500 returns. Only in the case of early 80’s when real bond yields surged a lot (when Paul Volcker raised rates to combat inflation) it had clearly a negative impact on the S&P500 and a subsequent decline in rates was welcomed by the markets. However, other than this, there’s no clear cut relationship. Actually in 60s and 70’s there was quite strong reverse relationship – a rise in real rates was associated with high S&P500 returns. Did that mean that higher rates were positive for stocks? Not necessarily, perhaps strong economy was good for stocks and at the same time pushed interest rates higher. 

Do notice that even in 80’s it took a very large spike in real bond yields to disrupt equity markets. Meanwhile these days higher rates move in line with higher inflation – in January 2018 a biannual change of the US 10-year real rate was negative! So this factor alone should not be a cause for a major market disruption. 

Does it mean, that the bull market is safe? Not necessarily. Even if real rates do not rise much investors might be concerned about a combination of higher nominal rates, higher inflation and slowing growth. At present there are some signs of the first two, a sign of slower growth could be a “make or break” factor for this bull market – but it’s not there yet.