Decoding the Factors Behind the Positive Relationship Between U.S. Bond Yields and Equities
Former JPMorgan Global Chief Economist (Ph.D. in Economics) and Current BrightQuery Chief Economist
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Theory suggests this is not supposed to occur. Low U.S. bond yields should boost stock prices as future earnings streams are worth more when we use a lower discount rate. In contrast, when bond yields rise, it will devalue the future stream of corporate earnings and depress equity prices.
Not surprisingly, financial market investors are perplexed that over the last 18 months, bond yields and the U.S. equity market have been positively correlated with each other. To some, that is unusual because, over long periods (e.g., 1970 to present), both variables have exhibited a negative 72.3% correlation. A negative relationship is, therefore, typical and expected. However, many other factors are often at play in the real world that may impact stock prices!
Source: S&P Dow Jones Indices, LLC and the St. Louis Federal Reserve Fred Database
A Fool’s Errand
Tracking the 12-month moving correlations between the 10-year Treasury bond yield and the S&P 500 index reveals that trying to predict the level of stock prices using bond yields can often be “a fool’s errand!” This correlation has fluctuated from a perfect negative to a perfect positive correlation (e.g., -1.0 to +1.0) over the past five decades!
Source: S&P Dow Jones Indices, LLC and the St. Louis Federal Reserve Fred Database and Author’s Statistical Computations
There is no doubt that equity markets key off a pandora’s box of other variables, including some that might influence the future path of bond yields. For this reason, we shifted our attention to long-term inflation expectations. Whenever long-term inflation expectations are rising or at high levels, it may be reasonable to assume that future bond yields could move higher and hurt equity prices.
Such evidence explains why equity market investors must look beyond current bond yields to forecast the movement in stock prices. That means that when bond yields rise while long-term inflation expectations decline or remain well anchored, it could pave the way for higher equity prices. Conversely, when bond yields are lower but long-term inflation expectations are rising, it might signal lower future equity prices.
This relationship is best expressed by the negative 47.1% correlation between the 10-year Yield & SP500 Index joint movements and the 12-month moving average of longer-term inflation expectations estimated by the Cleveland Federal Reserve. This negative correlation is more than twice as large as the negative 16.3% correlation between moving 10-year Treasury Yield & SP500 Index correlations and the 12-month annual change in consumer prices! These results also suggest that stock prices pay closer attention to long-term than short-term inflation. Not surprisingly, when treasury bond yields are low due to expansionary monetary policy while longer-term inflation expectations are rising, equity investors might fear that the Federal Reserve will pursue a more restrictive policy stance, push policy interest rates higher, and hurt future corporate earnings.
Source: S&P Dow Jones Indices, LLC, the St. Louis Federal Reserve Fred Database, the Cleveland Federal Reserve, and Author’s Statistical Computations
Summary and Concluding Thoughts
Although some investors have been perplexed by the recent positive relationship between U.S. Treasury bond yields and U.S. equity prices, the historical evidence reveals that many other variables, including long-term inflation expectations, can influence stock prices.
Interestingly, over the past 18 months, in which bond yields and equity prices have been positively correlated, they have been accompanied by a deceleration of short- and long-term inflation expectations. Such trends are a positive omen for the discounted stream of corporate earnings underlying equity prices and may explain why the S&P 500 Index surged by 24.2% in 2023!
As investors ponder the 2024 equity market outlook, it would behoove them to examine other catalysts beyond bond yields (e.g., geopolitical risks, the upcoming political elections, and potential changes in government tax policies, etc.) for clues on what might be in store for U.S. equity markets throughout the year!