Home / Opinion / What is the connection between bond yields and equity markets?

While central banks around the world move to combat rising inflation through the aggressive hiking of interest rates, the knock-on effect has been broad-based sell-offs in global share markets as investors rotate away from risk assets into safer assets. At the same time, there has also been a sell-off in bond markets which has seen prices fall and yields rise higher.

While central banks around the world move to combat rising inflation through the aggressive hiking of interest rates, the knock-on effect has been broad-based sell-offs in global share markets as investors rotate away from risk assets into safer assets. At the same time, there has also been a sell-off in bond markets which has seen prices fall and yields rise higher.

Thinking back to university days, one would recall a fundamental relationship that states that bond prices and stock prices are negatively or inversely correlated. However, the recent sell-off saw both bonds and equities fall simultaneously.

How could this be when economic theory states there’s an inverse relationship between bonds and share markets?

Bonds and stocks both compete for investor funds. Bonds offer safety in exchange for lower returns, and stocks offer greater returns but higher risks. This creates a situation where investors favour one over the other in order to rebalance their portfolio, during times of positive or negative economic growth. Here are the two scenarios explained:

Positive economic growth – When the economy is booming and the outlook is positive, investors tend to favour shares. As company earnings grow higher, share prices follow. The potential for profits is far greater than with bonds.

Negative economic growth – Bonds are essentially debt instruments issued by governments and corporates to raise capital. These are usually safer than stocks but still carry risk, mainly that of default. Bond investors receive regular interest repayments (yield) and receive the initial capital amount (the principal) at the maturity date. Because bonds are usually safer investments, their return is usually much lower than that of stocks. During times of volatility and stock market crashes, investors will often sell stocks in favour of safer bonds.

But in today’s case, the sudden case of rising inflation will play a part in both bonds and stocks. We know inflation can be damaging as it erodes future cash flows. So that means:

• Stocks – Rising inflation erodes future earnings, especially with growth stocks. These startups are built with the idea of growing earnings over the longer term. When inflation is low, these companies benefit because their value is determined by what their future earnings are going to be. However, if inflation and interest rates start to rise, it erodes the value of future company earnings. Investors tend to sell growth stocks in favour of value stocks, which are priced lower than their intrinsic value. Larger current cash flows are now more valuable than distant future returns.
• Bonds – If inflation rises higher than the bond’s rate of return, the real return is negative. Therefore, investors will sell these bonds and so bond prices fall. Short-term bonds are more resilient whereas long-term bonds will suffer losses.
• Bonds – However, as inflation drops below interest rates, investors will start to buy back bonds and prices will rise.

One thing to note: when there is a prolonged share market fall, bond prices generally start to rise as investors seek safe-haven assets and inflation starts to dip below interest rates. So to answer the question, is there an inverse relationship between bonds and share markets?

Yes, there is, but the exception to the rule is when inflation is the primary concern, rising above nominal rates to give negative real rates.