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Rising bond yields threaten to bite stocks

Those footsteps the stock market hears are the sound of rising bond yields.

Propelled by growing economic optimism and worries about inflation, government bond yields have been pushing higher for months. The yield on 10-year Canadian bonds is now about 3.5 per cent, up from less than 2.7 per cent in October. The increase has been even more dramatic in the United States, where 10-year Treasury yields have jumped to about 3.62 per cent from 2.4 per cent.

So far, the stock market hasn't blinked. In fact, stocks and bond yields have been marching higher in lockstep, as both are being driven by the improving economic outlook. But if bond yields continue to rise – as many observers expect – analysts say it's only a matter of time before higher borrowing costs start to exert a drag on the stock market.

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"Stocks and bond yields have both jumped as economic prospects improved since last fall," George Vasic, strategist with UBS Securities Canada, said in a note. "Now the key question for equity investors is at what level bond yields will resume their traditional negative relationship with equities and start to bite into valuations."

Based on his analysis of data over the past 20 years, the tipping point is a yield of about 4 per cent.

When the 10-year government bond yield is below that threshold, bond yields and the S&P/TSX composite index tend to move together, with a positive correlation of 0.49, Mr. Vasic found. That's to be expected, because very low bond yields are usually associated with sluggish or recessionary conditions, and when the economy starts to improve, yields and stocks both rise.

However, when bond yields are between 4 per cent and 6 per cent, stocks and bond yields tend to move in opposite directions, with a correlation of negative 0.56. In other words, when yields are already high and climbing, the stock market starts to feel the brunt of rising interest rates. (A correlation of 1 represents a perfect positive relationship, while negative 1 indicates a perfect inverse relationship.)

Sectors That Can Take the Heat

Higher bond yields are especially troublesome for interest-rate-sensitive stocks such as banks, which trade partly based on their dividend yields, Mr. Vasic said. When bond yields are rich, investors also demand higher dividend yields, which causes stock prices to fall. Higher bond yields also tend to compress price-to-earnings multiples generally, which is another reason stocks suffer when yields climb.

However, some sectors are more resilient than others in the face of rising bond yields. They include technology, industrials and consumer discretionary stocks. "If you believe the bias in bond yields is up, you should be rolling into those three sectors more so than the rest. That's the basic message," Mr. Vasic said in an interview.

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Bond yields haven't started to hurt stocks yet, but the days of benign yield increases may be numbered.

"There looks to be another 50 basis points [half a percentage point] 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.

This isn't the first time that bond yields and stocks have moved in tandem.

In the United States between 1955 and 1965, for instance, price-to-earnings multiples and bond yields rose at the same time, Société Générale said in a research note. More recently, there has been a positive correlation between equity prices and bond yields in post-bubble Japan, and in Europe both before and after the financial crisis.

The Magic Number: 5.2 Per Cent

Société Générale examined the relationship between German bond yields and European stocks, in particular, and found that the magic number for bond yields is 5.2 per cent.

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"When yields are below 5.2 per cent, the correlation between rates and equities is generally positive," it said. "In this case, inflation is generally low and rising rates are a reflection of stronger growth, or a move away from dangerously low inflation, both of which help equities."

When bond yields top 5.2 per cent, however, it's usually a danger sign for stocks.

"The more bond yields rise, the more negative the correlation becomes and the more toxic rising rates become for the equity market," it said. "In this case, inflation is generally higher than central banks would like it to be and fears of excessive monetary tightening typically weigh on the equity market."

For investors, it may be wise to have some cash on hand to take advantage of any meaningful pullbacks, Mr. Vasic said.

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