What Else Is Pushing A Sell-off?

 | Jan 31, 2018 12:34AM ET

The most widely-watched interest rate in the world rose to a level not seen in four years earlier this week.

The U.S. 10-year treasury yield, the global de-facto “risk-free” interest rate (the rate of return that theoretically bears no interest rate risk) rose to over 2.7 percent as bonds sold off.

Whilst a rising yield is a perfectly healthy by-product of an economy doing well, it exerts a tightening influence… in other words, it’s like applying the breaks on growth.

Corporate bond yields, for example, are priced and traded using their respective spread over the treasury rate. So when treasury yields rise, all else being equal, the cost of borrowing for companies in the bond market rises as well.

Thus, higher rates can constrain companies from borrowing to invest or grow.

An additional repercussion of rising bond yields is a corresponding sell-off in high dividend or yield stocks. Clearly, when bond market yields are low, then money will flow into dividend stocks (along with lower tier credit) looking for income.

As bond yields rise, those dividends start to look less attractive and as a result, those particular equity prices will readjust down – as price declines, their dividend yield therefore rises.

Sectors most at risk during a bond market sell-off include real estate stocks, real estate investment trusts (REITs), utilities, energy and basic materials – these are traditionally higher yielding equity sectors.

To give a sense of how far the pendulum has shifted, take a look at the following chart which shows the historical spread between dividend yield and short-term (2-year) treasury yields since the global financial crisis (GFC).

For well over half a decade, equities yielded 1 to 1.5 percent more than bonds. But since late last year, Federal Reserve tightening has not only closed the gap but reversed it entirely.