Global Bond Yields and Asset Prices
(An update 15Dec2022 is available)
Asset prices hinge on future cash flows of the asset and discount rate.
The discount rate is the sum of the risk-free rate, expected inflation rate and a risk premium specific to the asset’s expected cash flows. For long-duration assets, like, growth stocks, the risk-free rate is the 10-year sovereign bond yield. As the risk-free interest rate is a component of the discount rate, whenever interest rates go up, the discount rate increases and the asset price falls, provided other things remain unchanged.
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Related
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Bond yields, especially sovereign bond yields, are the building blocks of asset pricing. It's not a good idea to look at any single market in isolation. The bond, equity and forex markets are inter-linked; not to speak of global linkages. In markets, everything is connected—wars, virus outbreaks and supply chain disruptions.
Fiscal and Monetary Stimulus
The world over, both the monetary and fiscal authorities have been following unconventional policies--with the result asset prices are not reflecting their true fundamentals. In the US, the federal government had pumped in massive doses of economic support to the citizens who were impacted by the COVID-19 Pandemic.
This monetary and fiscal stimulus had propped up asset prices globally. Such artificial prop-up of financial markets led to less efficient price discovery of asset prices--creating its own problems for the global economy.
With following ultra-loose monetary policies for several years, central banks globally have distorted asset prices. With such distortions, investors should not assume that asset prices correctly reflect their true fundamentals.
With central bank-led asset price distortion, behaviour of economic agents changes, which is detrimental to the economy as a whole. Investors / speculators tend to look for easy and quick returns, speculating in stock or crypto-currency markets. With fixed income giving negative real rates, investors are forced to stick to risky assets even though price discovery mechanism of risky assets is in smithereens thanks to relentless bond buying (also known as quantitative easing or QE) by global central banks.
With interest rates near zero globally due to the unconventional monetary policies followed by major central banks for long, asset prices had remained elevated globally. That was before the start of 2022.
Since the beginning of 2022, investors started to price in steep rise in interest rates (especially in the US and the UK) and global stocks had started falling steeply. As inflationary pressures (aided by Russia’s invasion of Ukraine, rising crude oil prices and global supply chain bottlenecks) remained elevated, major central banks, like, the Federal Reserve, Bank of England and others started raising their benchmark interest rates (details in Table 2 below).
Investors were extrapolating asset prices in financial markets would only grow higher. But with rising inflationary expectations, investors’ assumptions of financial conditions had changed dramatically in the past six to eight months, leading to steep fall in global stocks, except those in the energy sector.
Disconnect between Inflation and Interest Rates
Before the advent of Quantitative Easing (QE) monetary policies, there was a close resemblance between inflation and interest rates. Whenever inflation rises and falls, interest rates used to rise and fall together. There was not a big difference between inflation rates and interest rates.
But post-QE, the situation is different. Have a look at the interest rates and inflation numbers provided in Table 3 below. For example, the consumer price inflation (CPI) in the US is 8.60 per cent (latest available print), but the Federal funds rate at 1.50-1.75 per cent is way below the inflation rate. It is not clear how the Fed will be able to control inflationary pressures with such massive difference between inflation and interest rate.
The distortion is worse in the Eurozone. The European Central Bank (ECB) has kept interest rate steadfastly at zero for a long time, whereas the CPI is elevated at above 8 per cent in the Euro area. Such distortion is not helping anyone. This kind of distortion is reflecting in currency market with the Euro plunging to its 20-year low against the US dollar (one Euro is now quoting at 1.02, close to par, versus the USD).
The US 10-year Treasury Yield
Due to the rising interest rates and higher inflationary expectations, the US 10-year Treasury yield rose by almost 200 basis points during 2022. The 10-year yield rose from a level of 1.51 per cent at the end of December 2021 to a recent peak of 3.48 per cent on 14 June 2022. Since then, the bond yield started falling and now is at 2.90 per cent (end-06Jul2022).
So, in the past three to four weeks, global stocks stopped their downward journey and started rising once again, though they are still down on a year-to-date basis.
To sum up, asset prices and bond yields are closely inter-connected. As asset price discovery has suffered heavily due to unconventional polices, current asset prices are not reflecting the actual fundamentals. It's time global central banks stopped such price distortions and halted stimulating the economies artificially for too long.
The following tables provide data on global bond yields, central bank interest rates and inflation rates:
Table 1: Global 10-year Bond Yields - how they changed between Dec2021 and Jun2022 >
Table 2: Global Interest Rates as of 30Jun2022 >
Table 3: Global Bond Yields, Interest Rates and Inflation Rates >
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Disclosure: I've vested interested in Indian stocks and other investments. It's safe to assume I've interest in the financial instruments / products discussed, if any.
Disclaimer: The analysis and opinion provided here are only for information purposes and should not be construed as investment advice. Investors should consult their own financial advisers before making any investments. The author is a CFA Charterholder with a vested interest in financial markets.
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He blogs at:
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