Rising bond yields: Investors taper their fear

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Bond yields are rising and equity investors are cheering them on. Oh, how things have changed over the past several months.

The last time the yield on the 10-year U.S. Treasury bond approached the 3 per cent threshold, in September, investors were freaking out.

They knew that the Federal Reserve was planning to taper its bond-buying stimulus program, known as quantitative easing, or QE, but they were far from confident over what the impact would be.

Back then – yes, just three months ago – they saw tapering as a threat to everything from the housing market to consumer spending to the bull market in stocks, since rising bond yields mean higher borrowing costs.

The S&P 500 suffered three dips of 4 per cent or more between May and September as the 10-year bond yield rose from 1.6 per cent to nearly 3 per cent. In particular, homebuilding stocks slid more than 30 per cent during this period.

You could see rising anxiety levels elsewhere, too. The CBOE Volatility Index – or VIX, a popular fear gauge – twice arose from a slumber during this period and spiked about 60 per cent.

Now, the Fed has made its move, announcing earlier this month that tapering will begin in January. Once again, the yield on the 10-year bond is close to 3 per cent after touching its highest level in more than two years.

But the atmosphere couldn't be more different: This time, it's all good.

The S&P 500 is close to a record high and on track to turn in its best annual performance since 1997, homebuilding stocks have recovered 26 per cent since September and the VIX is sleeping peacefully again.

What's so different now? For one thing, the economy is showing clearer signs of recovering, which makes tapering far easier to digest.

In the November payrolls report from the U.S. Labour Department, the unemployment rate fell to a five-year low of 7 per cent, surpassing economists' expectations.

As well, U.S. gross domestic product expanded by a surprisingly robust 4.1 per cent in the third quarter, revised up from an earlier estimate of 3.6-per-cent growth.

But just as important, the good economic news isn't worrying anyone that higher interest rates will follow: The Fed has made it crystal clear that winding down its bond-buying program has nothing to do with raising its key rate.

In fact, in its last monetary policy statement, released in mid-December, it stated that it would likely hold rates steady "well past the time" that the unemployment rate falls below 6.5 per cent – which had previously been seen as the threshold for raising rates.

The message is getting through to investors. Futures now suggest there is just a 24-per-cent chance that the Fed will raise its key interest rate by January, 2015, down from a 50 per cent chance when bond yields last spiked toward 3 per cent.

Of course, rising yields aren't good for bond prices. The Barclays index for long-term bonds has dipped more than 12 per cent this year.

But the hope among bullish observers is that the double-whammy of falling bond prices and rising stock prices will encourage more investors to rotate out of bonds and into stocks, propelling the bull market deeper into record-high territory even with the S&P 500 up 29 per cent this year.

So far, so good. But the enthusiasm for stocks rests on bond yields sticking fairly close to 3 per cent for the next year. According to a Bloomberg News survey, observers believe the yield on the 10-year bond will rise only slightly from the current level, to 3.4 per cent by the end of 2014.

Above that, there's no guarantee that the cheering in the stock market will continue. As we saw earlier this year, investors can get very nervous, very fast when bond yields rise. At 3 per cent, it would take only a modest increase in yields for nervousness to kick in.