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Why all investors cannot afford to ignore bond yield movements
Investing is often about looking for signals from the market such as corporate news, currency movements and economic data. They can help you to decide if it is time to buy or sell.
A major signal this year has been the increase in the yield on US Treasuries (aka US government bonds), which exceeded 3% last week for the first time in four years.
Increased expectations for inflation has worried people who own bonds as inflation erodes the value of their fixed payments in real terms. This has prompted many people to sell their bonds, driving down the price and driving up the yield.
Central banks like a certain level of inflation but they can also pull a lever to rein back inflation, namely by lifting interest rates.
In the US, solid economic conditions and a tight labour market helped to drive up inflation in February to 1.6% (as measured by the personal consumption expenditures price index), its largest increase since April 2017. This is still short of the Federal Reserve’s 2% target, so you may wonder why people are worried.
Economists point out the three-month annualised rate of gain is 2.8%, well ahead of target. Another measure to consider is the New York Fed’s underlying inflation gauge which was 3.14% in March. This measure includes over 100 macroeconomic and financial market variables as well as the usual basket of goods. There are expectations the Fed will keep lifting interest rates this year, perhaps twice more.
WHY DOES THIS MATTER?
Historically, such a move to tighten monetary policy changes the relationship between different maturities of US government debt.
Investors demand a higher coupon (or interest rate) to lend to the US government in the short term (the benchmark here is the two-year Treasury), a move which reduces the premium earned by lending to Uncle Sam for longer periods of time (for which the benchmarks are the 10-year and 30-year Treasuries).
Eventually, the yields on 2-year Treasuries will exceed that on the 10-year paper. This is known as an inverted yield curve and can signal a recession down the line.
Higher borrowing (as a result of interest rate hikes) can see companies reducing investment in their business including labour, which prompts delinquencies and defaults on debt and can trigger a recession.
The US 30-year mortgage rate, for example, is based on US Treasury yields and it now stands above 4.5% for the first time in nearly five years.
IMPACTING STOCK MARKETS
These movements are likely to be bad for stock markets as well as bonds – just remember that actions in the US can ripple across other geographic markets from a sentiment perspective.
Another way of looking at the situation is to consider that a potentially gloomier outlook could start to be priced into estimates for corporate profit growth. In turn that could lead to a de-rating of equities, essentially falling share prices.
Higher bond yields can also suck cash out of riskier stocks and back into fixed income which, in theory, comes with less capital risk.
The current situation is not a reason to panic and sell your investments. However, it does stress the importance of monitoring bond yields. Watch the 10-year Treasury yield as you may need to take protective action if it moves above 3.1% on a sustained basis as that would break a 30-year-plus downtrend. (DC)