Useful compass changes direction

Bond yield menace intrudes on equity market party

Bond yields are still low by historical standards. But they have been rising fast enough to erode the equity risk premium (ERP). That means that last week's pattern - falling share prices and rising yields - is likely to become more common.

So far in 2013, US stocks have risen in 12 of the 17 weeks in which Treasury yields increased. But last week the US S&P 500 Index fell 2.1 per cent while 10-year US yields hit two-year highs of 2.9 per cent.

Higher bond yields erode the allure of stocks which pay high dividends. And, over time, higher rates curb consumer and corporate borrowing and act as a brake on growth. Investors are recalibrating.

The ERP is one way of gauging the relative appeal of shares and bonds. It is a measure of the excess return investors demand for holding riskier stocks rather than the safest and most liquid government bonds.

The US ERP has fallen by about a quarter since the start of 2012, to 5.1 per cent, according to Societe Generale. Its models show that while the ERP is still above its post-1990 average of 3.9 per cent, it would only take a one percentage point increase in the US 10-year yield to push the measure down to the average. Such a move is well within the realms of possibility. And, the picture is similar in the Euro zone and UK. The British ERP is even closer to its long-term average, according to Societe Generale.

Of course, there is a long way to go before ERPs approach the exuberant 2000 lows - 1.2 per cent in the United States. The stock market rally doesn't look to be out of steam yet. Moreover, equities need not be as much in the thrall of bond market moves as they were during the financial and Euro zone crises.

Still, equity traders and investors are watching for the great inflexion point in Western monetary policy. As they bite their nails, sharp swings in the yields of the safest and most liquid bonds are more of a hazard than they have been for five years.