The 10-year Treasury yield is a crucial economic benchmark and market confidence indicator; Changes speak volumes about the economy and global market sentiment. Furthermore, economists frequently use it as a reliable indicator of inflation.
Traditionally, increases in the 10-year Treasury yield suggest worldwide economic confidence, while decreases show caution about global economic circumstances. This relationship, however, has evolved through time.
Understanding the relationship between yield and stock prices and how to interpret changes in the latter can help investors make better financial decisions about their portfolio and asset allocation. This article will look at the impact of 10-year Treasury yield movements and how they may affect one's portfolio. Then, we will discuss some current asset allocation strategies that align with changes in the 10-year yield.
10-Year Yield and Stock Relationship
The relationship between the 10-year yield and the stock market has altered several times in the past. From the 1970s to the early 2000s, stocks and bond yields were negatively correlated: Stocks were generally falling when rates were going up.
However, since the 2008 crisis, the Fed and other central banks across the world slashed interest rates to historic lows while pumping capital into the banking system by buying bonds on the open market. Although this approach appears to have been required and had the desired effect in aiding recovery and stabilizing the banking sector, it unavoidably distorted the bond market; Since then, stocks and bond yields have been moving in tandem.
One of the key takeaways from the figure above is the 5 percent cap, which has driven the evolution of the correlation between stocks and bonds. From 1970 through the early 2000s, when rates were above 5%, stock prices and bond yields were adversely correlated. On the other hand, they have been positively correlated when rates were below 5%, as they have been for the previous 20 years.
In short, analyzing the relationship between prices and yields is far from straightforward. A rise in Treasury yields can indicate a sign of risk appetite, but it can also reflect market expectations of a rate hike, which would have the opposite effect on equities.
Furthermore, global events and other unpredictable occurrences, such as the turmoil caused by the Covid-19 outbreak, substantially impact yields. As U.S. bonds are regarded as one of the safest assets in the world, demand surge when global events cause upheaval, thus resulting in lower yields.
Different Industries are Affected Differently by Rising Yields
When economic growth accelerates and yields rise, cyclical industries outperform the broader market, while defensive industries move in the opposite direction.
Financials, energy, materials, and components, for example, have typically outperformed in rising yields environments, as illustrated here. Secular and defensive industrial groups, on the other hand, underperformed in the same economic context.
Figure 3: Relative performance of Growth over Value stocks and 10-year yield (2010-2021). Source: BespokePremium
Growth and value stocks are another critical point to consider, as both categories behave differently to changes in the 10-year yield. With the latter being historically low for the past decades, historical data revealed that growth stocks consistently outperformed value stocks.
However, growth investments have recently underperformed in the current environment of high inflationary pressures and rising yields, as shown in the chart above. This could lead to a renewed attractiveness of value stocks.
What to Consider in Today's Climate
Although the 10-year yield is poised to increase, it remains way lower than the long-term historical average. Moreover, its relationship with market economic activity should remain unchanged: bond yields and stock prices should generally move in the same direction. This dynamic suggests that a rising 10-year yield is not necessarily harmful to investors.
On the other hand, inflation is a major current issue and threat. If inflation does not stabilize by 2022, the effects may have a detrimental effect on markets and the economy. Furthermore, this scenario could signal the return of a negative relationship between equity prices and bond yields.
Cyclicals, as previously said, thrive in rising rates and inflationary conditions. Similarly, even though growth companies have consistently outperformed value stocks over the last decade, the current financial environment suggests changing this tendency. Increasing their weight in a portfolio should be considered.
The Clarity of the 10-Year Yield Evaluation has Changed
While the 10-year yield evaluation used to be crisp and clear, that is no longer the case today. Rising yields might transmit multiple messages, some of which are contradictory. Therefore, rather than focusing solely on yields, investors should analyze how such a rise would affect their portfolio holdings and the relative growth prospects of each. Rising yields should not be a major problem if the overall outlook remains positive.
What matters most in the current financial climate is the components and sectors of a portfolio's overall performance. Considering cyclical and yield stocks may benefit a portfolio's current outlook, given the current difficult financial conditions.
Discover the Options Trading Secrets of Trading Professional
Learn proven tips and options trading strategies to find low-risk trades to maximize your profits. Get your FREE eBook now.