Will rising bond yields hurt stocks

The bond-equity cycle

Stock market traders are repeatedly concerned with the question of what really influences the movement of the stock markets. What are the right indicators and economic data to look at in order to best anticipate a turnaround in the equity markets? Complex models are created, labor market data, capital goods expenditure, state budgets, etc. are analyzed. The selection of indicators is huge and almost unmanageable. In addition, different indicators give different signals, some of which contradict each other. In short, the matter is very complex and difficult to understand.

This is especially true for us as equity investors. Above all, we want to deal with the companies themselves and not spend our valuable time analyzing macro data. Nevertheless, it is of course useful to have an overview of the macro situation in order to be able to adjust the risk in the portfolio, i.e. to increase the cash ratio when the market is overheating or to lower it when we are in an upward phase.

Matt King from Citigroup has developed a very interesting approach. This divides an economic cycle into four phases, each with different effects on the development of bonds and stocks. Indeed, we must be aware that the bond markets are much larger than the stock markets. This means that any signs of instability in the economy can supposedly be read on the bond and interest rate markets rather than on the stock markets. In this respect, bonds play a crucial role in this consideration. As with individual stocks, valuation is an important factor for the stock markets. Stocks that are too expensive will correct sooner or later.

Let's first take a look at the individual phases:

It becomes clear that the movements of bonds and stocks are different in all four phases. While the movements in phases 1 and 3 are opposite, the prices of bonds and stocks in phases 2 and 4 rise and fall in the same direction. We are talking about price increases for both asset classes. In the case of bonds, rising prices mean falling yields and falling prices mean rising yields. Since bonds are usually repaid at € 100, the return for investors is higher if the price is € 90, for example. The price gain is added to the coupon, i.e. the interest.

Phase 1

The 1st phase of the bond-stock cycle begins at the end of a recession. After the economic slowdown set in, interest rates have been lowered and money is cheap. In addition, investors still avoid shares in this phase, especially because trust in shares is still low and since companies often issue new shares in this phase in order to replenish their balance sheets with fresh equity. Bond prices, on the other hand, rise in the first phase, because companies fill their balance sheets with equity and the debt ratios fall as a result. This supposedly increases the security for bonds. Conversely, rising bond prices mean that bond yields are falling.

Phase 2

The economy is boosted by the low interest rates, which causes corporate profits and cash flows, and thus share prices, to rise again. Bond prices also continue to rise in phase 2, with the associated falling yields, which speaks of the falling risk against the background of an economy gaining momentum in this phase.

Phase 3

the 3rd phase of the bond-stock cycle is probably the trickiest. Here, shares are still on an upward trend due to the now prospering economy. But risk premiums and yields on bonds are already rising, due to rising corporate debt. In addition, investors are increasingly switching from the bond asset class to shares, which puts pressure on bonds and boosts share prices. The 3rd phase of the cycle is the one in which bubbles form on the stock markets and the valuation levels continue to rise as phase 3 matures. The warning signals from the bond markets are often overlooked.

Phase 4

Phase 4 is the classic bear market, in which bond and stock prices fall. Corporate profits are falling and corporate balance sheets deteriorate, resulting in increased profit warnings and bankruptcies. As a result, lending is becoming more restrictive and it is more difficult for companies to find fresh capital. Due to the fact that prices are falling across the board, in phase 4 it would be best to hold cash or government bonds with very good credit ratings.

The critical phase is therefore phase 3. The further the bond-equity cycle has progressed, the greater the likelihood that there will be a correction in the markets. In other words, the further the cycle progresses in phase 3, the higher the cash quota should be.

We have found that in phase 3 bond prices are already falling and the equity markets tend to ignore this signal. This in turn means that we, as equity investors, should take a close look at the bond market to see that the upward trend may already be well advanced.

There are two indicators for this from the bond sector, which I believe are important to watch. On the one hand, this is the yield curve and, on the other hand, there are the so-called credit spreads in the area of ​​high-yield bonds (junk bonds).

Yield curve

The yield curve shows the yields of bonds over different maturities. The curve is normally directed upwards, i.e. with lower returns at the end of the term and higher returns at the end of the term. The yield curve typically flattens out towards the end of an upward cycle, mostly because the central banks raise key interest rates and thus yields rise at the end of the short term. In addition, due to the increasingly dwindling short-term confidence, investors are simultaneously looking for long-term bonds, which means that their prices rise and yields fall. In extreme cases, the yield curve is even inverted, which means that short-term bond yields are quoted higher than long-term yields.

Now you don't have to constantly follow the entire yield curve. Rather, it is sufficient to form the difference between two points on the curve. To do this, you take a long-term bond, about a 10-year bond, and a short-term bond, such as a 1-year bond. If the yield curve is "normally" upwards, the difference will be positive, that is, the yield on the 10-year bond is above the yield on the 1-year bond. If the balance drops to zero or even turns negative, the short-term returns are higher than the long-term returns and the yield curve has an inverse shape. This is then a clear signal that the cycle may be nearing its end.

Credit spreads

Credit spreads describe the yield premium on corporate bonds over government bonds. Since corporate bonds are usually classified as riskier than government bonds, they are usually traded with a risk premium, i.e. with a higher return. However, this premium is not always the same; it rises and falls with the state of the economy. In booming economic phases, the default probabilities of bonds are estimated to be lower, for example, so that the credit spreads are lower. If the risk of corporate bond defaults increases, credit spreads increase. Rising credit spreads mean rising yields for such corporate bonds, which in turn is the result of falling bond prices. The prices are falling because investors sell such papers.

High-yield corporate bonds are particularly suitable for measuring credit spreads compared to quasi-fail-safe government bonds. The high-yield paper is used because the issuers of these paper usually have the weakest creditworthiness and are most likely to experience repayment difficulties. Junk bonds are therefore a kind of early warning. If the credit spread increases significantly, this means an increase in the probability of default for corporate bonds, as the risk of financial distress increases.

Stock valuations

Another indicator that the markets are already in the 3rd phase or at the end of this is the stock valuation. The higher the valuation level of stocks overall, the greater the potential height of fall. If stocks are valued cheaply, the risk is correspondingly lower and progress in the third phase should still be early.

As far as equity valuations are concerned, the classic valuation metrics such as P / E ratio, P / E ratio or dividend yield are certainly viable metrics, of course in terms of the overall market. The Shiller-CAPE is also a good key figure for assessing the valuation level of the overall market. With the Shiller-CAPE, the average profit of the last ten years is used as the basis for the P / E calculation. In this way, economic fluctuations are smoothed out. In addition, an adjustment for inflation is made.

Last but not least, companies' profit expectations are also an important factor. As long as companies expect rising results, slightly higher valuation levels may also be justified. If profits fall as expected, higher valuation levels are rather difficult to sustain. This applies both to individual titles, but also to the broad market. Economic departments of banks publish such figures for a while, which are often quoted in the press. You can also keep an eye on analyst estimates in this regard.

Where are we now in the cycle?

The big question now, of course, is where we are right now in the bond-stock cycle. If we take a look at the interest rate structure, it becomes clear that long-term interest rates are very low. The yield on 10-year German government bonds is just 0.1%. The short-term interest rates on 1-year government bonds are even in negative territory. In this respect, the yield curve tends to be very flat. The difference between the long-term and short-term returns is therefore only very slightly positive and close to the zero line. This is basically a negative indicator.

Junk bond credit spreads have risen significantly in recent months. This implies an increased probability of default of the underlying companies with poor creditworthiness and an increased risk sensitivity of the investors. With regard to credit spreads, it should be emphasized that a corresponding increase was recorded in the USA and Latin America in particular. In Europe, spreads have also risen, but not nearly as much as overseas. Last but not least, there has already been significant relaxation in the past few weeks.

In view of the valuation levels of the stock markets, we can state that this is quite moderate and nowhere near too high. Rather, the P / E ratios are below the historical average and the dividend distributions are at record levels. What put a strain on the stock markets in January were primarily fears of declining earnings expectations, against the background of growth concerns in China, but also the only moderate growth momentum worldwide. To what extent this will come true is of course difficult to predict. In our opinion, there is currently nothing to suggest a significant slowdown in the growth trend among companies. Many companies are only cautiously optimistic due to the uncertainties, but mostly assume increasing sales revenues. This should also make it possible to increase profits.

Typical signs of the end of the bond-equity cycle are in fact the appearance of bubbles on the stock exchanges. That would mean that valuations are overheated or that IPOs are carried out at horrific price levels. That's not the case. Earnings revisions by analysts are also not currently underway, which can be attributed to the unchanged confidence, albeit cautious, of the companies. So we are clearly in the 3rd phase of the cycle, only the degree of maturity is nowhere near very advanced. Rather, it could take a very long time before phase 4 occurs.


Estimating the economic situation is a particular concern of many investors in order to be able to better manage their own investments. However, the variety of indicators is almost infinite and it is very difficult, if not impossible, to make an accurate statement from them. The bond-equity cycle can be of great help in this regard. Using this approach, it can at least be determined which phase we are currently in on the markets. With the addition of a few other indicators, it can now be determined quite reliably whether one should hold more or fewer shares in the current phase. As I said, exact timing will never be possible, but knowing where we are roughly can be worth its weight in gold.

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