The dangers in rising bond yields

James Mackintosh
No accompanying rise in economic hopes could be bad news for shares
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orget negative interest rates. Forget Greece. Outside Europe, markets have been dominated
To get a sense of the scale of the rebound: the loss for holders of super-safe 10-year British
Gilts over the past 13 days is approaching 4 per cent, the third-biggest loss over such a short
period in the past two decades.
Japanese bondholders have lost less but, since yields bottomed in mid-January, their loss was
the third-worst since May 2008. Yields have more than doubled. US Treasuries have
performed similarly, while the eurozone has missed out, with a much smaller rise in German
yields.
Bond yields rise for many reasons: higher expected growth, and so inflation; less demand for
safety; a change in how central banks are expected to act, particularly around QE; more
uncertainty about the future path of rates; or fears about government creditworthiness.
Judging by the reaction of shares, this yield rise was growth-driven. Cyclical stocks, those
most sensitive to the economy, strongly outperformed the defensives best able to ride out
hard times. This was not just about oil. As the chart shows, it was true even excluding the
energy sector.
Yet, only a small part of the rise in yields seems to be down to rising inflation expectations.
The 10-year US yield is up by 48bp since its low at the end of last month, even after the
slight drop on Wednesday. About a quarter of the rise was down to higher inflation
expectations; the rest was due to a rise in the term premium the amount of the extra
yield to compensate for uncertainty about the future path of interest rates.

Last month, the term premium reached its lowest since 1961, according to estimates by the
New York Federal Reserve, and was negative. So it was due for a bounce. But a rise in the
term premium does not provide the same positive signal about the economy as higher hopes
of inflation.
If the term premium is on the way to normalising as it might if the Fed embarks on a series
of rate rises there is a long way to go from its still slightly negative level to reach the longrun average of 1.6 per cent. Such a rise in yields without any accompanying rise in economic
hopes could be very bad news for shares.
james.mackintosh@ft.com