Why Bond Yields Matter

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If you’ve been paying any attention to the markets lately, you’ll have noticed that volatility is back. The major indexes saw record single day drops only to recover just days later. While computerized trading was part of the problem, there was still a building volatility caused by an rapid rise in bond yields that sent the markets plummeting lower.

Most investors understand the inverse relationship bonds and yields have, but the relationship between stocks and yields is less clear. The mixed data has some investors confused about how the two actually interact, but after last week, it’s clear that investors will need to pay attention to rates when making investment decisions.

The relationship between yields and stock prices

When bond prices go down, yields go up and vice versa. The same relationship can be said of stocks and yields too, although the correlation isn’t as strong. Historically, stocks trend upwards, albeit with short term corrections and bear markets thrown in the mix. The question of when and how yields play a role requires closer examination to get an answer.

It’s important to note that the actual value of bond yields is irrelevant to stocks. The market can adapt to any level of interest rates and yields – it’s the rate of change that matters. Too fast of a rise doesn’t give companies enough time to hedge their bets and make appropriate plans regarding business loans and other operational expenses.

Over time, even if interest rates and yields trend higher, stocks will continue to march forward. A good example of this was the performance of the markets during the 1980’s. Inflation, interest rates, and yields were above historical averages, yet the stock market wasn’t adversely affected. In fact, it performed quite well during this time – the Dow Jones nearly doubled in value.

The last thing to consider is how inflation enters into the equation. Generally speaking, if yields and interest rates are rising, it’s because inflation is also rising. The difference between the rate of inflation and interest rates is where the real influence in stocks occurs. If interest rates are higher, there’s no discernible impact on stocks, but if inflation is higher then corporate earnings get squeezed and stocks fall.

One thing that investors will want to keep a close eye on is dividend paying stocks. While the markets in general can absorb higher rates, dividend stocks will have a harder time. When yields on less risky assets like bonds go up, dividend stocks begin to lose their appeal. After all, why take on more risk if you aren’t reaping a higher reward?

In practice, getting the right balance between yields, inflation and stock values is a constant challenge that falls to the Fed to deal with. That’s why the market pays close attention to what the Fed has to say about rates and future plans. Investors need to understand how these factors play a role in how the markets perform in order to be successful over the long term.