The power of a bond

Bond yields usually move at a glacial speed and therefore do not garner much attention from market commentators. But this week, the bond market sold off heavily (meaning yields are on the rise) and these sharp movements are spilling over into equity market volatility. In this week's report, we analyse why bond yields are heading north and discuss the longer term outlook for this hugely important asset class. Also, we take a look at why equity markets don't like higher bond yields.

Firstly, let's set the scene. As shown on the first chart below, back in late February the benchmark US 10-Year Government bond yield had fallen to around 4.50 percent. Concerns over a deflating US housing market and volatility in global equities saw investors buy bonds in search of safety, which pushed yields down.

However, since this time, the housing market appears to have stabilized (although we believe there will be more pain to come on this front) and with the Fed maintaining a hawkish stance on inflation, bond investors are selling; pushing yields higher. In just over three months, US 10-year bond yields have moved more than 50 basis points, from 4.5 to around 5.1 percent. While this may not seem much of a deal, in the sleepy world of bonds, this is a big move!

Another reason for higher yields is simply supply and demand. In last week's report, we highlighted that bond yields had been heading higher and speculated, "If there is any truth to China's diversification of reserves, we should see upward pressure on bond yields in the months ahead."

China has been a huge buyer of US bonds over the past few years. This is because the Asian giant runs a huge trade surplus with the US and it 'recycles' most of this back into US dollar based fixed interest securities (bonds).

China's policy has led to a huge build up of foreign exchange (FX) reserves and officials have recently stated their desire to diversify their FX holdings. This means less demand for US bonds. With supply still robust (the US must keep issuing bonds to pay for trade and budget deficits), prices are bound to fall.

While there are always various reasons behind movements in asset prices, for bonds, the main determinant is inflation. For some time now, our view has been that inflationary pressures in the global system are building.

However, the bond market has not agreed with this view. To nearly everyone's surprise, global bond yields have remained historically low, despite the global economy roaring along at a tremendous pace. This situation was behind Alan Greenspan's famous 'conundrum' comment.

But the bond market is now beginning to wise up to the realities of higher inflation. A chronically weak US dollar (which as the world's reserve currency has an inflationary impact), and soaring commodity prices finally appear to be signalling higher prices lay ahead.

So how do bond prices impact the stock market? As discussed last week "Higher bond yields are likely to have implications for stock market valuations and in particular highly priced, highly leveraged stocks."

Interest rates are effectively the cost of money. Put simply, the stock market likes cheap money and gets nervous when the cost of money rises. More specifically, the stock and bond markets compete for investor's capital and we can assess the attractiveness of each market by comparing yields.

A bond market yield is easy enough to determine. Currently, the yield on the 10-Year note is around 5.10 percent. To compare this return to the broader equity market, we need to obtain a price-to earnings (PE) ratio for the stockmarket. In the US we use the benchmark S&P500, where the PE ratio is 17.5 times. Now, to obtain the earnings yield of the S&P500, we invert the PE ratio, that is we divide 1 by 17.5, which equals 5.7 percent.

So, a 5.1 percent earnings yield on bonds compared to a 5.7 percent equity market earnings yield looks to favor stocks...right?

Wrong!

The 10-Year Government bond yield is considered 'risk-free' in that an owner of that bond will always receive the promised income stream as it's backed by the US government. To clarify - the owner will always receive the promised nominal income stream but the government provides no guarantees over real returns.

The equity market, in contrast, provides no guarantees and there is considerable risk related to the earnings yield. Therefore, the equity risk premium states that the stock market yield should include a premium over the bond market yield to compensate for the added risk. In recent years the equity risk premium has become increasingly thin and it remains so given the above numbers.

From this analysis, we can see why low interest rates support higher equity market PE ratios and vice versa. This is why the direction of bond rates is very important in assessing the overall direction of the stock market.

So where are bond yields heading? Over the next few weeks, we would expect the current sell-off to weaken and for the bond market to rally. In our opinion, the US economy remains susceptible to higher rates and authorities will do their best to keep market rates relatively stable.

Longer term, however, we believe bond yields are headed higher. To discern the major trend in bond yields, we need to view a chart over the long term. Below we show the 10-Year bond yield from the early 1960's. After peaking in the early 1980s, inflation and bond yields have been on a steady decline. This has helped propel the most powerful bull market in history.

However, bond yields appear to reached their low point in 2003 and have since been trending higher. Over the next few years, we believe this trend will continue, putting pressure on overall stock prices.

Our strategy to deal with this environment is twofold. Maintain a large weighting to the resource sector, and stick with attractively priced industrials. Most resource companies are generating strong cashflows and have solid balance sheets. Despite the prospect of rising interest rates, over the long term we believe commodities will continue to outperform.

A similar situation unfolded in the 1970s. The chart shows that bond rates were rising steeply at the time however commodities, including oil and gold, experienced once on a generation gains.

In an inflationary environment, we also favour large capitalization stocks that have pricing power and trade on relatively low PE's. When the easy money leaves the arena, the focus will return to fundamentals and that means valuations.

In summary, we wouldn't be surprised to see the bond market rally over the next few months as authorities fret over the impact of higher yields. However, over the next few years we see yields heading higher and this could weigh on the stock market.

We believe we are well prepared for this scenario. In our opinion, the Fat Prophets Portfolio is designed to withstand the pressures of rising interest rates and a rising inflationary environment. In forthcoming months, we look forward to discussing the various stocks we believe will deliver strong returns to Members, should our outlook for financial markets prove correct.