Will Investors Move From Stocks to Bonds?

There is an interesting article that was run on Market Watch.  The author discusses the fact that the 10-year yield has risen from 1.6% to over 2.8%.  He suggests that this is setting up bad news for the stock market, as investors can lock in better returns from U.S. Treasuries.  He runs some numbers with a scenario of where the 10-year yield hits 4.5%.

I think the author brings up an important point and he could end up being right.  However, at the same time, we do have to consider the different scenarios that could play out.

First, just because the 10-year yield has been going up as of late, it doesn't mean it will continue.  There are several scenarios we could see where the yield stops going up, or even goes back down.

Second, we have to consider the reasons for higher rates.

If the Fed slows down its "quantitative easing", then this could certainly force rates higher as other investors would not likely step in and buy government debt at the current rate.  If this is the case, then the author is probably correct that the stock market is in for trouble.  We have seen, just by words spoken by Fed officials, how the stock market can move up or down in anticipation of what the Fed is going to do.  The current stock market boom is living by the Fed's monetary inflation and it will likely die by the Fed's monetary inflation ending, or even slowing down.

Another scenario is that the Fed keeps up its monetary inflation (or even worse, steps it up) and we start to see higher price inflation.  Even with the Fed buying big amounts of government debt, we could still see rates rise due to a fear of future inflation.  So if the 10-year yield were to hit 4.5% in this case, then it may or may not spell the end of the stock market rally.  While stocks do not always do well in times of higher inflation (you can see some examples during the 1970s), stocks will generally benefit, at least in nominal terms, from a dollar that is being devalued.

The interesting thing is that if there is some kind of a major pullback in the stock market, we might see interest rates go back down lower from where they are now.  During times of recession, it is likely that investors will seek safety, assuming there is not a lot of fear about inflation.  We saw this in the fall of 2008, when bonds were the best investment around.  Whether you like it or not and whether you think it is rational or not, investors find safety in U.S. government debt.

So while the author may be correct that higher yields could pull some investors out of the stock market, it is also important to know that a lot of different scenarios could play out.  It is also hard to determine cause and effect.  Are investors leaving the stock market to get better yields in bonds, or are investors going to bonds simply because they want out of stocks?