Bond yields spike but stocks have cushion

Bond prices have fallen sharply recently, pushing global bond yields up and dragging stock markets down. Bond yields could continue to rise over the next few weeks as bond investors adjust expectations on the direction of interest rates but further damage to stock markets will probably be relatively limited.

Today, Bloomberg carried a story by Eric Martin entitled "Stock Rally May Fizzle as Bond Yields Rise on Fed Rate Concerns". The story says that the best may be over for the US stock market rally in 2007 as gains will slow in the second half of the year amid rising concern that the Federal Reserve will raise interest rates.

Last week, strong US economic data, signs of sustained inflationary pressures and interest rate hikes by central banks elsewhere in the world all combined to push bond yields up 15 basis points. The sell-off in bonds in turn led to a sell-off in equities, the Standard & Poor's 500 Index falling 1.9 percent last week to close at 1,507.67.

The fall in bond and stock markets was not restricted to the US. The story was the same in the rest of the world as well.

As the article explains, higher bond yields may lower corporate profits, make takeovers more expensive and weigh on stock market valuations.

However, there is a flip side to this, as pointed out by James Paulsen, chief investment strategist at Wells Capital Management in Minneapolis, in the article.

"The catalyst to this sell-off was a realization that the economy is growing far better than they thought," said Paulsen. "Ultimately, what's bad about that?"

Not bad at all, actually. Which means that stock investors should probably not over-react to the on-going correction in bonds.

This is especially since valuations in stock markets are not stretched. After the recent spike in bond yields, the 10-year Treasury note is yielding just over 5.1 percent. With the recent fall in stock prices, the S&P 500 is trading at a price earnings ratio of about 18, or an earnings yield of about 5.5 percent, still higher than the yield on the 10-year Treasury note.

In other words, there is still some slack in the valuation of stocks compared to bonds. Indeed, the Bloomberg article by Martin also points out that the S&P 500 remains below -- though only slightly -- Wall Street's average end-2007 estimate for the index of 1,550 based on a survey at the beginning of the year.

In fact, so far, it has looked as though it is the bond market that has been wrong-footed by the economy. Despite forecasts of a relatively shallow slowdown for the economy by most economists, including Federal Reserve officials, some bond investors had obviously bet on a rate cut by the Federal Reserve.

Indeed, looking at bond yields alone, one would have wondered whether the Federal Reserve had done anything to interest rates over the past few years. In early June 2004, the federal funds rate had been at 1.0 percent. Around the middle of May 2007, the federal funds rate was much higher at 5.25 percent. Over the same period, the yield on the 10-year Treasury went from 4.7 percent all the way to ... 4.7 percent!

Such a show of recalcitrance by the bond market was always going to invite some sort of punishment. With recent signs of an improving US economy and robust growth in the rest of the global economy, a bet on a Fed cut looks an increasingly poor one, and it is little wonder that yields have spiked up as investors abandon it.

However, with bond yields now close to the federal funds rate, any further rise in yields seems to me likely to be gradual and limited as long as the Federal Reserve continues to sit on its hands. Although Fed officials have consistently reiterated their concern about inflation, they have also consistently maintained that inflation is likely to moderate and are unlikely to hike rates in the near future.

Rather, the impetus for a continued rise in yields is likely to come from further tightening that is still expected from other central banks. Last week saw the European Central Bank and the Reserve Bank of New Zealand raise their respective benchmark rates by 25 basis points. The Bank of England and the Bank of Japan are also widely expected to raise rates further some time over the next few months.

Markets generally expect one or two more rate hikes from these central banks before the end of 2007. This should not put too much upward pressure on global bond yields.

On the other hand, one should never get complacent with markets. Market expectations can and do change quickly, as the recent rise in bond yields have shown.

And while stock markets may have a valuation cushion now, further increases in bond yields could make that cushion feel uncomfortably thin.