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U.S. inflation-adjusted bond yields have jumped this month and, according to Goldman Sachs strategist Ryan Hammond, this makes the current environment a dangerous one for equity investors.

Mr. Hammond estimates that the intra-month move higher in 10-year Treasury yields is a 1.4 standard deviation event. Historically, S&P 500 returns have been below average when yields move between one and two standard deviations, and turn negative when the two standard deviation threshold is met.

A rapid climb in inflation-adjusted yields is particularly ominous for technology and growth stocks. As I’ve written previously, there is an inverse correlation between real yields and the S&P 500 price to earnings ratio.

With real yields deeply mired in negative territory near negative 1 per cent in recent years – indicating that bond investors would lose money annually once inflation was taken into account – more investors allocated funds away from fixed income and into the technology-related growth stocks that currently dominate the benchmark. Lower real yields drove stock prices, and aggregate PE ratios, higher.

The U.S. inflation adjusted 10-year yield, as measured by Treasury Inflation Protected Securities (TIPS), has climbed from -1.09 per cent to -0.87 per cent since September 9th, and this has coincided with a 3.8 per cent month to date drop in the S&P 500. The technology sector got hit harder. The tech-heavy Nasdaq has fallen 4.2 per cent in September.

The process that saw falling real rates supporting rising stock prices is now working in reverse as rising yields are pushing equities lower.

Mr. Hammond emphasized that stock prices were better able to withstand climbing inflation-adjusted yields if accelerating economic growth, which helps profit expansion, was the main driver. Unfortunately that is not the case now. “Today,” writes the strategist, “[U.S] economic growth is decelerating, the FOMC is expected to announce the start of tapering at its November meeting, and our economists have downgraded China’s economic growth forecasts.”

The 10-year can be tracked here at the Federal Reserve Economic Data site, and I recommend that investors do so. After a long period of unprecedentedly low inflation-adjusted yields, further moves higher in yields would pose a substantial risk to stock valuations and prices.

-- Scott Barlow, Globe and Mail market strategist

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