Stock markets around the world fell on Tuesday, dragged lower by fears that spiking bond yields will puncture the rising balloon of share prices.
Shareholders fret that interest rates are beginning a sustained increase. If so, that would be ominous news for today's levitating equity markets.
Over the past decade, stocks have climbed higher and higher because of TINA – the notion that There Is No Alternative to buying shares when bonds are paying next to nothing.
But if bonds start offering payouts that aren't so comically low, the balance of power shifts. The question is how much of a rise in bond yields it will take to tempt investors away from stocks.
For now, everyone is watching the 10-year U.S. Treasury bond, a global benchmark for long-term expectations. On Monday, its yield rose above 2.70 per cent, breaking through a key resistance line.
On Tuesday, the 10-year Treasury yield continued to hover around 2.72 per cent, a big increase from the 2.04 per cent it was paying in September and the most it's delivered since May 2014.
The recent surge in yields reminds some observers of similar spikes just before Black Monday in 1987 and in June 2007, on the eve of the financial crisis.
To be sure, nobody is predicting a catastrophe of such magnitude right now. The global economy is humming along at its best clip in years, while corporate results are coming in strong.
But stocks, especially in the United States, look vulnerable to a correction. They are extremely expensive in comparison to their long-term earnings. Bonds are looking increasingly enticing, especially after the recent run-up in yields.
In the U.S., a two-year government bond now pays 2.12 per cent, compared with the 1.8 per cent dividend yield on the S&P 500. In Canada, stocks are still the payout champs, but their advantage over bonds has been shrinking.
Shareholders are paying attention to this worrisome trend. In Toronto, the S&P/TSX fell 0.86 per cent on Tuesday, while the benchmark S&P 500 index in the United States declined 1.09 per cent. That followed falls in markets from London to Tokyo.
The losses in key markets over the past two days are minor compared with the enormous run-up in share prices in recent months, but they underline growing concerns about where bond yields are headed next.
One reason for concern is flickers of rising inflation in the U.S. Higher inflation usually translates into higher bond yields.
A common way to measure inflation expectations is by looking at the breakeven rate – the difference between the yield on a normal 10-year Treasury bond and an inflation-protected one of similar maturity. Right now, breakeven rates indicate investors anticipate inflation of just over 2 per cent a year during the coming decade, up sharply from what they were expecting this past summer.
Another ground for worry is the impact of U.S. tax reform. The legislation lowers corporate tax rates and increases the after-tax earnings of U.S. companies. However, it is also likely to increase the federal government's budget deficit and result in greater demand for savings to finance Washington's budget hole. All things being equal, that should mean Treasury rates will have to move higher to attract more lenders.
Meanwhile, interest rates are edging up in most developed countries, as governments show signs of unwinding crisis-era stimulus programs and the global economy picks up speed.
Budget worries and a brightening global economy may power even higher yields in the future. For now though, the run-up appears to mainly reflect expectations of higher inflation. The real yield on a 10-year U.S. Treasury – the amount of extra buying power that bond investors earn after inflation – is still barely above zero.
Where bond yields go next will hinge on how aggressively the U.S. Federal Reserve intends to move to control inflation. It releases its latest policy statement on Wednesday. Any sign the Fed intends to take a more muscular than expected approach to raising interest rates is likely to put pressure on stock prices.
John Higgins of Capital Economics calculates that if the 10-year Treasury yield climbs steadily to 3.5 per cent, a level in keeping with Fed projections, the average real return for bonds during the coming decade will be around zero.
That is decidedly unimpressive. Here's the kicker, though: If stocks revert to historical levels of profit margins and valuations, they will lose more than 2 per cent a year in real terms. Suddenly, bonds don't look like such a bad deal at all.