In the Markets Now: Yields, Yields, Yields

Bond Yields And Stock Market Volatility

Bonds have been driving stock market volatility and rising bond yields have become a big story for stock market investors. We take a closer look at the relationship.

One of the more interesting aspects of today's world is that the primary driver of stock market volatility hasn't been stocks at all, but bonds. With the Federal Reserve recently raising short-term borrowing costs for the first time since 2023 and the 10-year Treasury yield hitting new multi-decade highs, rising bond yields have become one of the biggest stories on investors’ minds. Given that the stock/bond relationship is the bedrock of many portfolios, this extra attention makes some sense.

The Fed raises interest rates to tighten monetary policy – aiming to reduce inflation risk by slowing the economy. Besides raising borrowing costs for consumers and companies, higher yields also pressure stock market valuations by making bonds a competitive alternative. So it follows that when rates rise, stock market volatility can rise too. The compounding factor is that higher yields also weigh on bonds because bond prices move lower when bond yields move higher. Altogether, periods of rapidly rising yields raise the risk of an environment where both stocks and bonds struggle, as was the case in 2022. These are the potential headwinds of rising yields.

What drives yields higher? For shorter-term bonds, the answer is fairly clean: the Federal Reserve largely determines the direction of short-term interest rates as part of its dual mandate to promote maximum employment and price stability. Last year, the Fed slashed rates as the labor market weakened and inflation moderated. This year, that dynamic has reversed: the labor market is looking quite a bit healthier and higher inflation has been stickier than hoped (partly due to the war in Iran’s impact on oil prices, refining capacity, etc.). In September, the Fed raised interest rates by 0.25 percentage points, and the bond market is pricing in another three or four hikes by the end of 2027.

For longer-term Treasury bonds, the rise in yields reflects a cornucopia of catalysts, a few of which we dig into below. But first, it’s worth noting that although today's yields may seem high, history suggests they are far closer to “normal” than those seen during the post-2008, pre-pandemic world when governments around the world pushed interest rates toward zero to stimulate economic recovery after the Great Financial Crisis. But that doesn’t make today’s move less worthy of analysis. So what are the drivers of the recent rise in longer-term bond yields? I think five (often inter-related) forces are worth digging deeper into:

• Large fiscal deficits. The U.S. and many other governments are running budget deficits that are historically large outside the context of a recession. To finance spending, the Treasury must issue an ever-larger quantity of bonds. When supply rises faster than demand, investors typically require more attractive yields to absorb new bonds hitting the market. A counterpoint – at least to the debt and deficit being the primary driver of higher yields – is that long-term bond yields have been higher at many points in history when the fiscal situation was much healthier (for instance, the last time the federal government ran a budget surplus, 10-year yields were even higher than they are today).
• Inflation and inflation uncertainty. In a deglobalizing world increasingly defined by geopolitical conflict and material shortages (from energy to industrial metals to compute), inflation has remained stubbornly above the Fed’s target rate of 2.0%. Add on reshoring and infrastructure spending, growing electricity demand from AI and data centers, potential wage pressure from labor shortages, etc., and one can see how the low inflation environment experienced post-2008 is unlikely to return anytime soon. In addition to spurring Fed rate hikes, expectations for higher inflation can also push yields up because investors demand more compensation if they expect future interest payments to be worth less.
• A rising term premium. Functionally, the term premium is compensation for uncertainty. Over the life of a longer-term bond, inflation and interest rates can move differently than expected, so investors demand a premium for owning a long-term bond rather than repeatedly reinvesting in short-term bonds. With large government deficits, inflation pressures, and general AI uncertainty, investors seem to want more compensation for long-term commitments today.
• Strong economic growth. Ah, some good news. The economy has repeatedly proven stronger than expected, and third quarter growth looks like it will be well above longer-term trends. As long as growth is positive and recession risks are contained, investors have less need to seek safety in Treasurys. This puts upward pressure on yields, while also contributing to the inflation anxiety identified above (i.e., strong growth à robust demand à inflation risk).
• A shift in buyers. Sources of demand that supported the Treasury market for years may be less powerful at the margin today: the Federal Reserve is aiming to shrink its balance sheet (or at least, pull back from an active role in buying Treasury bonds), foreign central banks are not accumulating Treasurys at the same pace as they once did, and commercial banks remain limited by regulation in their ability to load up on government debt. With some traditional buyers stepping back, even if only slightly, yields may need to rise to attract new types of private investor.

Will yields continue to pressure markets? On the stock market side, it’s true that rising yields present a growing headwind to returns, particularly in rate-sensitive sectors (e.g., housing). However, it’s also true that higher interest rates have not universally been associated with lower returns, especially when strong economic growth is one of the main drivers.

And while rate hike cycles have ended in recession more often than not, there is a long and variable lag time in between. Forward returns from the first rate hike in a cycle, even looking out as far as three years, tend to be quite strong. So while investor angst about the recent move in yields is understandable, the actual impact to stock market returns is more nuanced than headlines might make it seem.

On the fixed-income side, higher yields are already creating a more compelling setup. On a more tactical level, Baird Strategas’ Tom Tzitzouris recently addressed the rising term premium, saying he believed that if something were to go wrong in the global economy, the term premium will compress quickly. He went on to say, “at about 80 basis points (0.80 percentage points) of term premium, we estimate that you’d get about an 8% price increase from a 10-year Treasury in a really painful risk-off movement [for stocks]. Now, if the equity market is off 15%, that's not going completely offset equity market weakness, but it begins to provide some balance.” Said another way, the rise in yields might be painful now, but it sets bonds up to be a better hedge against future stock market weakness.

And that is the biggest takeaway – for high-quality bonds, starting yield remains the best available guide to longer-term return potential. The normalization of yields has made it a painful few years, but it sets the stage for a much better risk/return profile going forward. As Baird Private Wealth’s Aaron Sopinski writes, “Today’s higher yield environment allows many high-quality bonds to contribute a larger portion of an investor’s income needs than was generally possible during the previous decade…in addition to generating cash flow, fixed income may provide diversification benefits during periods of equity market stress.”

There is no doubt that the upward move in yields has created real challenges for portfolios in the post-pandemic environment. But they have also helped to restore something that investors went without for much of the past decade: meaningful income and a stronger potential cushion against future stock market volatility.

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