The title of today’s article may be surprising for several retail investors due to the constant media headlines about the high levels of inflation in most parts of the world.
However, despite the clear need for the major central banks to hike interest rates further in the immediate future in order to suppress the level of inflation, several economists predict we may indeed be nearing a time when bond yields peak. This is an important consideration not only for investors exposed to the bond market but also all other investors who have a greater risk appetite and, as a result, have a large allocation to shares in their investment portfolios.
In fact, the publication of lower-than-expected inflation data in the US last Thursday sparked a massive rally in both the equity and bond markets globally late last week. The annual rise of the US consumer price index was reported at 7.7% in October compared to a forecast for a rise of 8%. This was the lowest 12-month increase since January 2022 and a sharp drop from an annual rate of 8.2% in September.
These inflation readings gave investors confidence that the Federal Reserve’s sharp interest rate hikes in recent months (the US central bank delivered four consecutive rate rises of 0.75 percentage points each) are already having the desired effect of taming inflation, and as a result, that the Fed would be easing the pace of future rate hikes.
US Treasury yields plunged after the data was released last Thursday while equity markets soared, especially the share prices of technology companies. In fact, while the Dow Jones Industrial Average index jumped over 1,200 points last Thursday (equivalent to a 3.7% rise), the S&P 500 index gained 5.5% and the Nasdaq Composite surged about 7.4%. Last Thursday’s rally ranks among the sharpest daily gains since 2020.
US Treasury yields plunged after the data was released last Thursday while equity markets soared, especially the share prices of technology companies
In the bond markets, the yield on the two-year Treasury note, which is particularly sensitive to interest rate movements, fell 0.25 percentage points to 4.33% − its largest drop since October 2008. Since yields and bond prices move inversely, the decline in yields implies a significant rally in bond prices. Likewise, the yield on the 10-year US Treasury note fell to 3.828% last Thursday from 4.149% the prior day (the biggest daily decline since March 2009). A few weeks ago, the yield on the 10-year US Treasury note touched a multi-year high of 4.32%.
Many investors may ask why movements in bond yields significantly affect the way equity markets fluctuate. Equity markets reflect the valuations of companies, and one of the most common ways to value a company is by using a discounted cash flow method. This attempts to calculate the value of a company today, based on estimates of the amount of cash it can generate in future. This method relies on the principle that the value of money in future is worth less than today. A discount rate is used as part of the calculation to translate future cash flows into a present-day value. The higher the discount rate used in the calculation, the lower the value attributable to future cash flows. The discount rate used in such valuations is typically based on the 10-year government bond yield, often referred to as the risk-free rate.
On this basis, rising yields negatively affect the current market value of companies whose valuations are based on high future cash flows (such as high-growth technology companies). In fact, rising US Treasury yields (which jumped from around 1.50% at the end of 2021 to above 4% recently) and the resultant strengthening of the US dollar have been among the two main factors that led to the sharp downturn of equity markets. Conversely, the decline in yields last week positively affects company valuations.
Another important consideration of higher yields on movements in equity markets is the relative attractiveness of bonds over shares. With yields at historically low levels in recent years, more investors were moving into riskier investments such as shares in order to seek higher returns. However, as yields rise, some investors would tend to move away from shares into government or corporate bonds.
Although inflation levels in Europe are still elevated and the European Central Bank will clearly continue to hike rates in the coming months, the developments in the US last Thursday also resulted in a fall in eurozone bond yields. The yield on the 10-year German bund, the eurozone benchmark, slumped from 2.16% to below 2% immediately after the latest US inflation figure was published last Thursday. Last month, the yield on the 10-year German bund touched a multi-year high of 2.53%.
Within the local context, the movement in bond yields internationally and especially across the eurozone is important due to the daily pricing mechanism adopted by the Central Bank of Malta in its role as a ‘market maker’ for Malta Government Stocks. This in turn affects the pricing on the primary market for new MGSs and indirectly also for corporate bonds.
The notion that bond yields could be reaching peak levels is therefore important for investors to digest especially at a time when numerous new issues are taking place concurrently, which is unprecedented by local market standards.
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