What to Deduce from Rising Bond Yields

If the 30-year bond yield were a growth stock, you’d definitely want it in your portfolio. In fact, it would be one of the best performing stocks of the last two years.

Already this year, the yield on the 30-year Treasury bond has jumped 10% – or about double the gain of the S&P 500 Index. Over the last two years, the 30-year yield has soared a whopping 78%, versus the S&P’s 53% advance.

But bond yields are not a growth stock. They are a reflection of both credit demand and inflation expectations. For example, when credit demand and inflation expectations are both low, bond yields typically fall…as they did in late 2008. But when credit demand and inflation expectations are on the rise, bond yields typically rise as well.

What, therefore, should we deduce from the relatively steep ascent of bond yields over the past few months? Is credit demand climbing? Not really.

According to data from the Federal Reserve, consumer credit outstanding is still declining sharply. Economist David Rosenberg reports that total revolving credit outstanding has been dropping steadily – from $989 billion at the end of 2008 to $894 billion at the end of 2009 to $826 billion at the end of last year.

So if bond yields are climbing in the context of contracting credit demand, rising inflation expectations must be to blame…and that’s probably not a good thing for the stock market.

Historically, rising bond yields compete with the stock market for investment dollars. As interest rates rise, the competition becomes more acute, causing share prices to languish or fall.

For now, however, inflation-phobia is not a pervasive sentiment. Few investors seem to care that food prices are soaring, that T-bond yields are climbing across the entire yield curve or that almost every central bank in Asia has started raising interest rates to combat inflation.

The stock market is rising because the stock market is rising. That’s all we know and, apparently, all we need to know. The S&P 500 Index has nearly doubled since the dark days of March 2009. It’s been a great run. The Wall Street folks tell us that this great big rally is reflecting “improving economic data and higher-than-estimated earnings.” And probably that’s true…or partly true.

The rest of the truth might be that the S&P 500 is reflecting Ben Bernanke’s massive money-printing exercise. Eventually, this exercise will produce inflation, or at least it should. But for the moment, inflation is showing up most prominently in the stock market.

Enjoy it while it lasts. When inflation starts showing up in the bond market and in the rest of the real world, share prices tend to struggle.

Eric Fry
for The Daily Reckoning

The Daily Reckoning