How Rising Treasury Yields Impact Stock Markets

As a financial planner, understanding market behavior is crucial for making informed decisions. One phenomenon that often raises questions is why stock markets tend to decline when U.S. Treasury yields rise. While the relationship between the bond market and the stock market can be complex, there are key reasons why rising yields often lead to market dips.

What Are U.S. Treasury Yields?

U.S. Treasury yields represent the return investors receive when they buy government bonds. These bonds are considered some of the safest investments in the world because they are backed by the full faith and credit of the U.S. government. Yields fluctuate based on demand for these bonds and expectations about future interest rates.

Why Do U.S. Treasury Yields Rise?

Yields generally rise in response to several factors, including:

• Inflation Expectations: When inflation rises, the value of future bond payments decreases, prompting investors to demand higher yields to compensate for that loss in value.
• Federal Reserve Policy: The Federal Reserve may raise interest rates to control inflation, which indirectly pushes Treasury yields higher.
• Economic Growth: Strong economic growth often leads to higher interest rates, which can cause bond yields to rise as well.

The Inverse Relationship Between Bond Yields and Prices

Before delving into the stock market, it’s important to understand the relationship between bond prices and yields. When bond yields rise, bond prices fall. This is because newly issued bonds will offer higher interest payments, making existing bonds with lower yields less attractive. As bond prices decline, investors may start shifting their portfolios.

Why Do Rising Yields Affect the Stock Market?

Here are the main reasons why rising Treasury yields can send shockwaves through the stock market:

1. Increased Borrowing Costs

Rising Treasury yields often signal higher interest rates, which increases borrowing costs for companies. When businesses have to pay more to borrow, their profits can take a hit. This tends to lower their stock prices, especially for companies with high debt levels or those reliant on borrowing for growth.

2. Competition with Stocks

When Treasury yields rise, bonds become more attractive relative to stocks. U.S. Treasuries are considered a safer investment, so higher yields can draw investors away from the riskier stock market. As investors shift their money into bonds, stock prices may decline due to reduced demand.

3. Future Cash Flow Discounting

In the world of finance, companies are valued based on their expected future cash flows. Rising Treasury yields lead to higher discount rates used to calculate the present value of those cash flows. As a result, the higher the yield, the less valuable those future earnings appear, which can cause stock valuations to drop.

4. Impact on Growth Stocks

Growth stocks, particularly in sectors like technology, are hit hardest when yields rise. These companies are valued for their future growth potential, and rising yields reduce the present value of their future earnings. This makes them more vulnerable in a high-yield environment.

Historical Examples of Market Reaction to Rising Yields

A well-known example of how rising yields affect the market occurred in late 2018. The Federal Reserve increased interest rates multiple times, which led to a significant rise in Treasury yields. As a result, the stock market experienced a correction, with the S&P 500 dropping nearly 20% from its peak by the end of the year.

More recently, in 2023, as inflation concerns persisted, Treasury yields spiked again, and markets reacted with increased volatility, particularly in growth-oriented sectors.

Conclusion: The Importance of a Balanced Approach

Understanding the relationship between U.S. Treasury yields and market performance is key to navigating market volatility. While rising yields can lead to downward pressure on stocks, a diversified portfolio that includes both equities and fixed-income investments can help mitigate risk. This is why we feel working with a financial planner who understands market dynamics is essential for long-term success.

At Full Circle Financial Planning, we help clients build portfolios designed to weather changing market conditions. If you have questions about how rising yields might impact your investments, we’re here to help.

Sources:

• Federal Reserve Bank of St. Louis (FRED). “Interest Rates, Inflation, and Market Performance.”
• U.S. Department of the Treasury. “Daily Treasury Yield Curve Rates.”

Past market performance is no guarantee of future investment performance or success.