Modern portfolio theory loosely states that it is the composition of stocks, bonds, and cash as a class that make a difference in returns, not a particular stock or bond. It is whether you are in stocks or bonds as an aggregate, as opposed to owning IBM or Microsoft. We find ourselves in a current financial environment that is testing professional money managers to determine how to weight their portfolios. At the crux of the issue is the 10 Year U.S. Treasury note, the bellwether debt indicator on bond yields.
The yield curve expresses the risk versus return nature of debt instruments like notes and bonds. One would expect that yields, or returns on shorter issues like the U.S. Treasure 2 Year note would be lower than that of a longer term note like the U.S. 10 Year Note or the U.S. 30 Year bond. Exposure to the marketplace is risk. The longer you are in the market, the more you are at investment risk. It makes sense that investors should be compensated more for holding longer term debt securities.
So what does this have to do the stocks you currently own? Modern portfolio theory says it has a lot to do. Bond yields are a leading indicator of future stock prices. As the yields of treasury notes and bonds goes it, it becomes more competitive with rates of return in the stock market. Think about it like this. When was the last time you were really excited about putting your money in a certificate of deposit (CD)? I’m think circa late 70’s, early 80’s era of stagflation. Also remember that when comparing treasury bonds to equities, the bonds as well as CD’s are risk free, backed by the good faith of the U.S. government.
Société Générale estimates, assuming the risk premium remains unchanged, the S&P 500 should fall to 2,509 when the 10-year yield rises to 3.00%, as the chart below shows.
Several other events are also correlated to these figures. Yields will rise as the Treasury increases debt sales to finance expanding government deficits and as the Federal Reserve trims its bond portfolio. On a more basic, consumer consumption note, higher yields will generally cost you more to finance, when you buy things like houses and cars. Most consumer debt is tied to these benchmark government yields. As the higher they go, the more you will pay in interest, and hence the more you will spend in total on a financed house or car.
