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[Londres, 25, Reuters BREAKINGVIEWS]— Just as a dream that started softly turns into a nightmare, a “good” rise in bond yields has the potential to turn into a disaster in the stock market.
Yields on 10-year Treasuries doubled in less than five months, reaching an annual high of 1.45% on the 25th. Rising yields are not a desirable phenomenon for companies as they increase borrowing costs. and they reduce the present value of cash flow from the perspective of shareholders through higher discount rates. That said, equity markets tend to perform well, as long as the higher returns are due to a better economic outlook.
So far, there is no doubt that this is the situation. Economic activity is recovering with the vaccination with the new coronavirus vaccine, and the large-scale economic measures of the President of the United States, Biden, will help this recovery. A Bank of America survey of institutional investors around the world shows that the percentage of respondents expecting a global economic improvement this year is the highest ever. That’s why the S&P 500 composite index is up 12%, while the 10-year Treasury yield has doubled, although the stock market has seen some turmoil earlier this week.
The Federal Reserve is also helping equity investors focus on the bright side of things. Powell delivered a clear message on the 24th that monetary tightening will be postponed for quite some time. The monetary tightening is a regular feast of rising stock prices.
The president said the Fed will not raise rates until inflation exceeds 2%. He said that such a situation could take place more than three years later. The Fed may want to raise rates after seeing a strong recovery in the economy and the job market.
But this adds another risk for equity investors. The Fed has announced a new strategy adopted last year that will allow inflation to exceed 2% over a period of time. In other words, it is not clear how much to hike and for how long. Bond yields will skyrocket if inflation rises more than expected. If the cost of equity is seen to rise at a faster rate than growth, corporate valuations will decline and equity investors will be in trouble.
Problems can also arise from other directions. For decades, the Fed has slowed monetary tightening as prices begin to rise due to economic growth. If the positive side of the inflation rate causes wages to rise, which in turn amplifies the cycle of rising prices and then wages, you may have to hit the brake pedal harder than before. None of these are imminent threats. Still, stock investors should have a headache medication on hand.
● Background news
* The 10-year US Treasury yield reached a one-year high of 1.45% on the 25th.
* Fed Chairman Powell testified in the Finance Committee of the US House of Representatives on the 24th, reiterating his determination to return the economy to full employment and, unless prices continue to rise sharply problematic, there are concerns about inflation. He acknowledged that there was almost no such thing.
* The Fed has so far stated that it will refrain from raising rates until inflation exceeds 2%. “It may take more than three years,” Powell said yesterday.
(I am a columnist for “Reuters Breaking views”. This column is based on my personal opinion).
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