Why Are Bonds Causing Stock Markets to Fall?

Stock markets fall bonds

Author: Tim Phillips

March 9, 2021

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Specific stocks around the world have recently been experiencing heavy falls in their share prices. That has obviously hit investors hard. However, the sell-off has been more focused on so-called “growth stocks”.

What are these? They tend to be companies that are growing their revenues at a fast rate and are typically found in the technology sector.

Yet, nothing has fundamentally changed with many of these businesses. And with the Covid-19 vaccine seeing wider distribution, the prospects for the global economy actually look bright.

So, what’s the deal with the massive “sea of red” that investors are witnessing? Mainly it comes down to the bond market. Here’s how the bond market is causing volatility in the stock market.

Rising yields

The closest thing to a “risk-free” investment is a US 10-year Treasury note, which for all intents and purposes we can view as a bond that’s backed by the US government.

In other words, you buy this bond and you receive a set “yield” on it in terms of annual income. The thing is, a huge amount of financial assets are tied to the yield of the 10-year Treasury.

For example, when the yield is extremely low, like it was last year, then high-growth technology stocks start to look extremely attractive.

That’s because why should global investors accept an ultra-low 10-year Treasury yield (which went as low as 0.6% last August) when many companies are producing an earnings yield that is several percentage points higher?

This “earnings yield” is essentially the earnings per share (EPS) divided by the share price. When there is a large gap between the overall market’s earnings yield and the 10-year Treasury yield then fast-growth stocks look great.

Now, though, the tables have turned. The 10-year Treasury yield has more than doubled to 1.6% and is at its highest level in more than a year.

If we look back over a longer stretch, though, we can see that the 10-year yield has actually been falling for the past 40 years or so (see below).

10-year US Treasury yield

Treasury yield 10-year

Source: macrotrends.net as of 5 March 2021

Stay calm and keep investing

Given the huge amount of money that is being pumped into the US economy via stimulus cheques and lower interest rates, many people are afraid this will spark inflation.

So what’s the takeaway? As long-term investors, we should ignore talk of “Treasury yields” and “inflation” and focus on buying great businesses that will thrive in any environment.

In that sense, not much has changed over the past few weeks for these individual technology businesses. They’re still performing extremely well and providing crucial services to tens of millions of customers.

It just happens that their share prices are now much cheaper than they were a month ago.

Stocks, not stonks

Last year’s gains in the stock market, we should all admit, were an anomaly. Many growth stocks saw their share prices exploded higher, sometimes by a factor of six or seven times.

That’s not normal but given how much growth their businesses saw amid a global pandemic, investors flocked to them.

However, as much as we like to hear the antics of the wsb crowd and “meme stocks” such as GameStop Inc (NYSE:GME), stocks don’t always go up.

History has shown us that yields and inflation don’t necessarily mean great businesses (that just so happen to be termed “growth stocks”) will perform poorly.

We need to stay invested over time and ride the inevitable, yet admittedly depressing, “lows” in markets as well as the euphoric highs.

Disclaimer: ProsperUs Head of Content Tim Phillips doesn’t own shares of any companies mentioned.

About the Author: Tim Phillips

Tim, based in Singapore but from Hong Kong, caught the investing bug as a teenager and is a passionate advocate of responsible long-term investing as a great way to build wealth. He has worked in various content roles at Schroders and the Motley Fool, with a focus on Asian stocks, but believes in buying great businesses – wherever they may be. In his spare time, Tim enjoys running after his two year-old son, playing football and practicing yoga.