Time is running out for the U.S
We in canada have a few more quarters. But its coming
For investors, the phrase “bond yields rising” can sound an awful lot like “dead man walking.” After all, there’s been nothing like a rise in the cost of borrowing to kill momentum on rallying stock markets over the past few years.
Needless to say, evidence of upward pressure on bond yields in Canada and U.S. is causing growing concern and debate as equities on both sides of the border race to reach new highs.
“I’m getting very concerned about it,” says Peter Gibson, a managing director of portfolio strategy and quantitative research at CIBC World Markets. “If yields stay in their present range, I am optimistic that equities can move higher, but very quickly we are moving towards a significant turning point.”
As of Friday’s close, the 10-year U.S. treasury yield was 3.58%, a level it has traded near for much of February after a steady climb from a low of 2.5% in August. The almost 50% rise in yields since the summer has coincided with a number of factors, notably an improving U.S. economy and QE2, the U.S. Federal Reserve’s program to buy US$600-billion worth of U.S. treasuries through June.
While the very act of this second round of quantitative easing is designed to keep yields low in order to stimulate the economy, it’s implementation has helped fuel an exodus out of bonds and into equities.
Own their own, higher bond yields are negative for economic growth, raising the cost of capital to business and pressuring mortgage rates and for many analysts, a further rise in the 10-year yield to 4% would be enough to derail the current leg in the equity rally that has seen stocks rise around the world more than 85% in two years. This threshold is largely based on the experience of the past few years, including last April, when a 4% yield resulted in a 16% correction in the S&P 500.
Mr. Gibson says so-called floors and ceilings in the U.S. 10-year bond yield have been reliable indicators of the rise and fall of bond and equity prices since at least 1998 if not longer. At floors, bond prices have tumbled and stocks have rallied, while at ceilings, stocks have plummeted and bond prices have risen.
For example, he notes that the S&P 500 collapsed after hitting a 6.7% yield ceiling in 2000 and did the same again in 2007 when the ceiling of 5.2% was reached.
For now, his implied ceiling is 3.78%, just 20 basis points above today’s actual yield. If the U.S. benchmark bond yield breaches this level, he believes it will send equity markets dramatically lower or even worse, could trigger another economic crisis.
“The Fed doesn’t want to tighten like they did in 2000 and 2007 because if they do, maybe the markets fall 50% and the economy goes into another recession. But if quantitative easing doesn’t work, and I think it will, they may be forced to tighten aggressively. Because if they don’t do something, the bond market will panic, yields will rise even more rapidly and the stock and housing markets might collapse.”
Here in Canada, where the 10-year government of Canada bond yield has also jumped significantly since the fall, rising 70 basis points to roughly 3.46%, the potential consequences are presumably no less serious.
George Vasic, a strategist at UBS AG, says the level at which bond yields start to bite into stock valuations, is also near 4%. Specifically, he said the correlation between the TSX and 10-year yield is positive when it’s below 4% but negative when the bond yield reaches 4% and higher.
“Accordingly, there looks to be another 50 basis points or so where improving economic data will lift both bond yields and stock levels, after which higher yields will likely start to act as a drag on equity valuations,” he said.
Not everyone believes bond yields pose an imminent threat. Avery Shenfeld, CIBC’s chief economist, for one, believes rising yields in Canada and south of the border are simply reflect a flight away from the safety of government bonds into equities by investors who are convinced that better economic times are ahead.
With that, he says, also comes recognition from capital markets that growth will eventually lift inflation and lead to central bank tightening, but for the good news about the economy that is driving asset rotation overrides any negative impact those factors might have on earnings down the road.
“If a rotation into stocks is part of the story, it’s circular to argue that the higher yields are an equity rally killer. If faster growth is the source of increased inflation and central bank rate expectations, it’s also circular to argue that the higher yields jeopardize the expansion, at least until we are much further into a tightening cycle,” he says.
Pierre Lapointe, a global macro strategist at Brockhouse Cooper, points out the breaking point for U.S. treasury yields to negatively affect equity prices has been closer to 6%, a potential problem to worry about in 2012 and beyond.
“Historically, rising treasury bond yields have indeed been bad for stocks – but at much higher levels of interest rates,” he says.
dpett@nationalpost.com
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