Rising bond yields caused a sell-off in shares. I tell you why.
Ok, so yesterday, I told you why we saw a surge in bond yields last week. Today, I’m going to tell you why that caused a sell-off in the share market.
(My bet: it won’t be the last time this year…)
Remember this is a mystery. In the good old days, when everything made sense, stocks and bonds tended to move in opposite directions.
Now a crash in one seems to cause a crash in the other.
But I’m going to tell you what’s going on, and in doing that, I’m going to shine a light on the dark-heart of the modern economy.
You need to understand this.
Ok, so bond yields spiked, shares got sold off. Why?
There’s three ways rising bond yields can affect share prices, but only the last one really matters.
1. The Debt Burden
Ok so first, remember what a bond is – a promise by the government to pay you a set rate of interest on the money you lend them.
A bond yield is the return the bond offers, relative to its price (like a property yield).
In effect, a rise in government bond yields is an increase in the risk-free rate of interest.
Since governments are the least-risk proposition in the economy, the interest they pay borrowers works like a benchmark. All other interest rates in the economy key off this one.
So if they start paying more interest, then everyone else in the economy starts paying more too.
And this is the first transmission mechanism.
Rising interest rates are bad for corporates with a lot of debt. Their interest burden goes up, eating into their cashflow and profitability.
So that could impact how much people are willing to pay for shares in a company.
That said, right now, corporate debt burdens aren’t particularly high.
Particularly when you consider the amount of cash they have on reserve, the debt-to-profits ratio (black line) is pretty normal.
So it’s probably not about markets freaking out about how much debt companies have.
2. Discounted Cash Flows
Shares entitle you to a ‘share’ of a company’s profit, from here to eternity.
How much you value that income stream depends to a degree on how much you ‘discount’ money in the future relative to money today.
The ‘discount present value’ is a financial calculation where interest rates are a key ingredient.
Basically, the more interest rates go up, the more you value money in the moment, and the less you are willing to pay for money in the future.
So if interest rates rise, then the value of shares (a claim on future money) falls.
(I suspect this effect is probably going to be marginal.)
3. The Outlook for EZ Money
The rise in bond yields last week was largely driven by inflation – or the expectations of inflation.
People are looking at the massive amount of money coming into the system ($3tn in under 12 months!)
They’re looking at all this and thinking, you know, this is probably going to create inflation.
And it was expectations of inflation that drove the pick up in bond yields. If inflation rises, then lenders demand a higher rate, to get the same real return.
And so people started thinking about the outlook for inflation, and said, “You know, I think I need a better return from these bonds to compensate me for the risk.”
So rates rose.
But hang on, why is that story bad for shares.
Rising inflation is coming out of an over-heating economy. Surely that’s good news for
sales, profits and share prices, right?
But that’s the thing. Share prices have surged over the past twelve months on the back of expectations that interest rates were going to remain low, and the EZ money would remain on tap.
Now though, people are worried The Fed (and the RBA) might want to wind things back a bit.
In fact, in the US, markets are now pricing in more or less a full hike in 2022, as well as two in 2023. (That trajectory seems a little aggressive to me, but there you go.)
But this is the fear: The Fed takes away all the booze from the party.
Super crazy valuations (Tesla is up 700%!) were based on the belief that cheap money would be here for years.
Fears that all that might be taken away was enough to make investors take stock of their positions. And some, it seemed, felt a little exposed.
And so that, to me, is the biggest reason why a rise in bond yields caused a sell-off in shares.
Markets had become addicted to EZ money. Even the prospect that it might, maybe, be taken away, was enough to cause a minor-meltdown.
And this is the situation we’re in.
Mega-money is the new normal. Asset inflation is baked in.
Take away the money, and the money party ends.
And ends in tears.
And so how do we play it?
Well, asset inflation is baked in. You’ve just got to invest where valuations aren’t already stretched and drunken.
So ask yourself this: Has your house price gone up 700% in the past 12 months?