Rising interest rates and falling bond prices continue to rattle equity markets. Bond commentary even made it into Warren Buffett’s annual shareholder letter (27 Feb), with the ‘Sage of Omaha’ saying that bonds face a ‘bleak future’.

From September 1981 the US 10-year bond yield had fallen 94% from 15.8% to 0.93% by the end of 2020 before rising by 53% to the current 1.43%, still low by historical standards. UK 10-year bond yields sit at 0.86%.

It’s important to note that not all bond prices have been affected to the same extent. Longer dated bonds and lower coupon (interest rate) bonds are more sensitive to rising interest rates which means they have fared worse than shorter dated issues.

Government bonds have seen the brunt of the selling, while individual company bonds, referred to as credit, have been spared because they are more sensitive to the economic outlook which has been improving.

AN UNUSUAL OCCURRENCE

Periods of falling bond prices (rising yields) and falling equity prices are relatively rare, happening around 13% of the time over the last 40 years, according to Morgan Stanley.

Typically, such an occurrence is accompanied by central banks increasing rates to combat an overheating economy towards the end of an economic cycle.

Contrast that with today’s environment and the difference couldn’t be starker. The US Federal Reserve has explicitly said it won’t start raising interest rates until it sees labour market tightness which doesn’t seem very likely any time soon.

After all, weekly US jobless numbers have been rising at over 500,000, and investors will be watching for signs of that slowing when February’s monthly non-farm payrolls data is released on 5 March.

RISING INPUT COSTS

Even though Western economies are still operating below capacity, an increasing number of companies have recently highlighted supply chain bottlenecks leading to material shortages and rising shipping costs.

For example, the January UK IHS Markit survey showed delivery times deteriorating by the most since the series began 29 year ago.

Add to the mix rising commodity prices, copper prices recently traded close to their all-time high and the upward move in interest rates starts to make sense from a bondholder’s perspective.

In other words, bond investors are demanding higher interest payments to compensate them for the risk of higher inflation.

So far, the consensus view remains higher interest rates will not be able to derail further progress for equities while a recovering economy will continue to provide support for ‘cheap’ cyclical companies and penalise ‘expensive’ growth companies.

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