Commentary > Bid and Ask
Could bonds snuff stocks?
Higher Treasury yields could draw money away from equities.
July 22, 2003: 4:36 PM EDT
By Justin Lahart, CNN/Money Senior Writer

NEW YORK (CNN/Money) - Maybe the reason stocks have had such a hard time gaining ground recently has less to do with worries about the economy or future earnings growth than it does with the spike up in interest rates.

People said the flurry of buying that brought the 10-year Treasury yield to a 45-year low of 3.11 percent June 13 was panicky, but it paled in comparison to the selling that's taken place since. With Monday's rout in the bond market, the yield on the 10-year rose to 4.21 percent, its highest level since early December.

The last time the yield rose so much in so short a time was back in the 1980s, when absolute yields were much higher. In percentage terms, the last time the yield moved so much was... well, never.

One can come up with all sorts of prosaic -- and legitimate -- reasons equity investors should care about this. Rising rates could snuff the mortgage lending boom and cut companies away from capital, putting economic recovery at risk. Further, the sharp runup in yields smells like somebody getting caught offsides and rushing to get out. If a big player's portfolio is in the midst of blowing up, that could have major repercussions.

But the biggest reason the rise in yields could damage stocks is rather pedestrian: Bonds have rather suddenly begun to look a lot more attractive relative to stocks. After three years of pain, many investors are unsure of what sort of returns stocks will throw off over the next several years. The returns on Treasurys, on the other hand, are backed by the full faith and credit of the United States of America.

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Justin Lahart, senior writer at CNN/Money, talks about bonds and their impact on Wall Street.

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One way to think about this is through the Fed model, a valuation tool which says that stocks' earnings yield -- expected earnings over the next year divided by price -- should be about equal to the 10-year Treasury yield. (Be warned that lots of people complain about the Fed model, but it's useful here.) On that basis fair value on the S&P 500 fell by more than a quarter between June 13 and the close on Monday.

If bonds begin to offer a little competition for stocks here, however, it might not be such a bad thing for equity investors in the long run. If yields can maintain their current levels, the economy will face far fewer headwinds on its way to recovery. And economic recovery, more than anything else, is what the stock market needs at this point.  Top of page

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