• Higher bond yields

Last August the 10 year U.S Treasury yield fell to a low of 0.5%. Today, the yield is 1.4% as bond markets focus on the possible inflation implications of a $1.9 trillion fiscal stimulus package, coming at a time when the American economy appears about to enjoy a period of strong cyclical growth. But although many commentators believe yields will climb higher, in the U.S, the U.K and in other major economies, it seems unlikely that this is the great bond market reversal that some doom-mongers have been expecting for the past decade.

• Why?

Inflation, though expected to rise, is also expected to be a temporary phenomenon. It will reflect a one-off jump in consumer and business demand, and temporary supply bottlenecks. Few economists are predicting a wages-prices inflation spiral similar to what we saw in the 1970s, on account of the excess spare capacity in the labour force (ie, unemployment and under-employment). However, any sign of wage inflation would justify more fear amongst stock market investors.

Most economists expect ‘the world of small numbers’ that came about after the financial crisis to persist after the pandemic. JP Morgan Asset Management, for instance, are forecasting U.S inflation to stabilise at around 2%, from 1.4% in January. Assuming continued Fed buying of $120bn of bonds a month in its current asset purchase program (a policy reiterated yesterday by Fed chair Jay Powell), they predict 10 year Treasury yields peaking at 3% in the current cycle.

• Cyclicals

Stock and credit markets should be able to take such numbers in their stride, thanks to expected strong corporate earnings growth arising from the recovery. It is for this reason that economically sensitive sectors, such as travel, consumer discretionary, industrials and mining, have shrugged off the increase in bond yields. Indeed, one cyclical sector -financials – positively revels in the steeper yield curves that we are seeing across major bond markets. As long term yields increase relative to short term yields and overnight interest rates, the spread between what banks pay to borrow money, and what they can charge their own borrowers, increases. This increases their profits.

• Tech stocks

Particularly in the U.S, have been trading at expensive valuations in recent months. These are justified so long as the return on risk free alternatives, such as government bonds, is miniscule. But as risk free rates (such as government bond yields) rise, the relative attractiveness of these ‘long duration’ assets (so called because investors are buying into a promise of perhaps distant future earnings) declines.

• Bond proxies

Another group of stocks are also at risk from higher bond yields. These are utilities, insurers and other dull but reliable dividend payers, that have acquired the description of ‘bond proxies’. As global interest rates and bond yields fell in the decade before the pandemic, their generous and stable dividend yields meant that income-seeking investors increasing included them in their portfolios, rather than fixed income. But these now look vulnerable as bond yields rise. The best will be able to grow their earnings and their dividends sufficient to counter the increasingly strong pull of government bonds. But others, in declining sectors or those with very limited room for expansion, will be vulnerable to an investor sell-off.