The biggest factor impacting your portfolio you probably didn't know about

Thu 02 Nov 23, 1:41pm (AEST)
winning investors cheering market moves
Source: Freepik

Key Points

  • The bond market is the largest and most important market in the world, and it has a major impact on stocks
  • Rapid and steep increases in bond yields since August have triggered sharp losses in the stock market
  • The yield on long term US bonds fell sharply yesterday allowing stocks to recover

You've no doubt heard the good news by now. The US Federal Reserve's Federal Open Market Committee (FOMC) decided to keep the official US cash rate on hold at 5.25-5.50%. Status quo, no surprises, nothing to see here. Right?

Well, there was a massive move overnight in the most important market for your portfolio. Most investors will probably draw a line between the rally in the US stock market and our own market today and postulate "We're up because they're up".

Yes, and no.

Yes, the local bourse will get a boost today in line with increases in other major global stock indices, but each of these indices are rising because of just one reason: Bond yields fell. More specifically, longer term bond yields fell, and they fell big. The yield on the US 30-year Treasury Bond fell 0.17% to 4.93%. Remember, the FOMC usually deals in 0.25% changes, so the bond market effectively delivered a sizeable rate cut to investors.

Contrary to what most stock investors probably think, the bond market is the biggest and most important financial market in the world. The bond market sets the price of money. The price of money impacts the price every other asset, from the price of fine art, to the price of that little lithium company in the bottom drawer of your portfolio kicking over rocks in the desert somewhere.

Bonds 101

Bonds are just fancy IOU's. They function a bit like a term deposit but are issued by companies and governments to help them fund their operations. Investors buy and sell bonds much like they buy and sell shares. For their investment, they typically get a scheduled interest payment and their capital back at the term of the bond. The interest is referred to as the bond's 'coupon', and terms are known up front and range between anything from 1-day to 30-years.

You can see from this definition bonds represent a great deal of certainty. You know what you're going to get and when you're going to get it. Unlike stocks! Stock values fluctuate daily based upon their expected profits. It's this greater degree of certainty which makes bonds such an attractive investment for those looking for reliable, low volatility returns. Think massive pension and superannuation funds here, as well as banking and insurance companies, and all levels of government. Bonds are big business.

One of the major reasons your portfolio has been so mediocre for the last 18-months is bond yields pretty much everywhere in the world have been steadily and rapidly rising. And rise they must as central banks have (relatively all of a sudden) jacked up interest rates in an effort to fight inflation in a post-COVID world. Bond yields usually track the price of official interest rates because official rates set the benchmark for the price of money. Competition ensures that as official interest rates increase, bond issuers must offer investors higher yields to entice them to buy their bonds.

In short, since early 2022, central bankers have made the price of money substantially more expensive. This is good if you have money and wish to invest it safely in new bond purchases at higher interest rates, but it's terrible if you want to borrow money, or if you already have a mountain of debt.

Bonds vs Stocks (Hint: bonds win!)

This is where we link the bond market back to the stock market. Companies generally have some level of debt. Higher yields increases companies' debt burdens, and therefore lower their profits. There's a double whammy here. Higher yields also increase household debt burdens, causing us to spend less, which generally means lower revenues for companies, and therefore lower profits. Lower profits means lower stock prices.

The triple whammy comes from how analysts at big fund managers value the price of a company's shares. Typically, they'll reduce the value of a company's future earnings based upon the prevailing risk-free market rate. The higher this rate, the more punitive the impact on a company's future earnings, and therefore the lower the valuation of the company's shares.

Let's look at a few charts which help explain just how big the moves in bond markets have been.

usa 30-year t-note yield chart
US 30-year Bond yield, weekly chart, last 10 years

US 30-year bonds yields are important because they are a benchmark for US mortgage rates. Obviously, higher mortgage rates are going to have a negative impact on the US economy and their stock market. At the recent peak of 5.18%, the US 30-year bond yield is well above its 10-year highs and is substantially above the 0.71% low hit in the wake of the COVID-19 pandemic back in March 2020. (Interestingly, the US 30-year bond yield is actually at a level not seen since June 2007 - just before the GFC!).

usa 30-year t-note yield vs s&p500 relative performance Mar 2020 to present
US 30-year Bond yields vs S&P500 relative performance since COVID

When bond yields rise in a gradual and orderly fashion, stock usually don’t fare too poorly. Often bond yields rise because an economy is strong: Strong economy, strong stock market is how it usually goes. We can see from the above relative performance chart of US 30-year bond yields and S&P500 since the COVID-19 pandemic that there are prolonged periods where yields and stocks are rising at the same time. Usually, this is based upon a "The economy is getting better and interest rate expectations are fairly certain" scenario.

In particular, the rise in 30-year bond yield between March 2020 and November 2021 coincided with a 60% rally in stocks. The period between October 2022 and then end of July 2023 was also a strong period for stocks despite rising yields.

Not so fantastic was the period in between these two where bond yields spiked dramatically higher from November 2021, and so began the last bear market in stocks. This was all to do with messaging from the FOMC that rates would have to transition from accommodative (due to the pandemic) to restrictive (due to the looming threat of inflation). The FOMC officially began their hiking schedule in March 2022 and the rest is as they say history.

For much of this year, the stock market largely ignored the grind higher in long term yields. We even saw a new bull market commence in the Nasdaq and S&P500. It was brief however, because the last rapid acceleration in US 30-year bond yields since August has proved to be another decisive blow against the bulls.

usa 30-year t-note yield vs s&p500 relative performance 1 Aug to present
US 30-year Bond yields vs S&P500 relative performance since 1 Aug

You can see from the above relative performance chart beginning 1 August, how dramatically the relationship between rising bond yields and stock prices has played out. Yields spiked up and stock prices spiked down. And here we are! Stocks are up today because last night long term bond yields pulled back in a big way.

Forewarned equals forearmed

There are a bunch of other really important and interesting reasons why long term US yields have risen so far so quickly, and perhaps we'll investigate them in future articles. For now you just need to know that rapidly rising long term yields is likely to be very bad for your portfolio, and vice-versa.

Yields are rising in response to the continued threat of inflation, and the growing belief central banks will use higher official rates to combat it. The heart of the higher bond yields problem lies with uncertainty as to how high official rates can go. Markets don't like uncertainty and we know this sends capital to the side lines. Even worse for stocks, the yield which can be earned while one is waiting on the side lines is substantial. So, clearly there are some serious issues playing out in markets which stock investors must be aware of.

For now, I just wanted to highlight the most important driver of the value of your portfolio you probably didn't even know about! Now that you understand how the relationship between bond yields and stock prices is playing out in markets, you'll be able to monitor this fascinating narrative. After all, to be forewarned is to be forearmed!

Written By

Carl Capolingua

Content Editor

Carl has over 30-years investing experience, helping investors navigate several bull and bear markets over this time. He is a well respected markets commentator who specialises in how the global macro impacts Australian and US equities. Carl has a passion for technical analysis and has taught his unique brand of price-action trend following to thousands of Aussie investors.

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