It was not too long ago when we were talking about the U.S. 10-year Treasury Yield hitting all-time lows. At the low in March 2020, the 10Yr fell below 0.4%. At the onset of the pandemic, bond yields were coming down as investors flocked to the safety of bonds.   

Fast forward one year later, markets are dealing with a rising yield environment with the 10-year surpassing the 1.5% level. With stock indices trading near their highs, a higher rate environment could pose a threat to stocks as it could attract investors to buy bonds and reduce their exposure to stocks.

A focal reason for the rising yields is the increased expectations of inflation from a growing post-covid economy. The Fed acknowledges that short-term inflation could arise from increased spending due to tremendous pent-up demand; however, this inflation has been called “transitory” in nature as there is still tremendous slack in the economy and the labor market will take longer to recover. In other words, the Fed is trying to communicate that they do not believe inflation is here to stay. For stock investors, this is a comforting notion as it implies bond yields should not have a continuous meteoric rise.

Based on the chart below, there are expectations that yields could quickly surpass the pre-pandemic levels as the economic outlook improves. Historically, this has been followed by a period where yields are more range-bound. Therefore, we could potentially see yields range between 1.5% to 2% for the next couple of years before the next rate hike cycle from the Fed. Hence, this is still considered a “low rate environment”, and is typically a constructive setup for stocks.

The premise behind higher yields negatively impacting stock prices stems from stock market valuations. In simple terms, higher yields mean a company’s future cash flows are discounted at higher rates. Theoretically, stock prices are the discounted value of their future cash flows. Hence, by discounting at higher rates, stock prices should be lower. However, this largely ignores the growth rate of a company. If a company’s corporate earnings and growth remain in line or ahead of the rise in rates, the impact on the stock could be neutral. Therefore, investors should spend more time sifting through those companies who have been effective at cutting costs over the last 12 months and can benefit from a post-covid revenue growth, which when combined could lead to increased margins and earnings. Overall, rising yields due to an improving economy is actually a good omen for stocks in the long term. Traditionally, a higher inflation and yield environment is favorable for asset-heavy and cyclical sectors like financials, resources, and industrials where rising asset values and rising prices can be passed down to customers.  Ultimately, the focus, for any long term investor, should remain on strong fundamentals and a resilient growth profile that can keep up with the potential rise in inflation.