As 10-year Treasury yields climb, investors are fixated on 3 percent, a level where many fear an equity market meltdown. Yet that threshold has no fundamental relevance. Instead, investors should try to understand why yields are rising, and draw the right investment conclusions.
A common misconception is that equity prices are inversely related to bond yields. Surely, that is wrong. The Nikkei lost almost three-quarters of its value in the 1990s, a period that coincided with a plunge in Japanese government bond yields. More recently, global equities advanced strongly in the second half of 2017, along with bond yields.
No simple rule links equity and bond performance. The best framework for understanding the dynamic is the dividend discount model, which relates the equity market multiple to trend growth, the equity risk premium and the bond yield (or the “risk-free” rate). And, all else equal, this model says that the equity multiple rises if bond yields or the equity risk premium fall, or if long-term growth improves.