Bond Yield: The Stock Market’s Worst Enemy
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Global stock markets recovered during the first 2-3 trading days of 2025 after a consolidation at the end of last year. However, it wasn’t long before they dropped again in the second week of the year, led by the U.S. stock market. The cause this time was rising bond yields.
What is Bond Yield?
First, we need to get to know and understand Bond Yield, which is the main factor here.
“Government Bond Yield,” or simply “Bond Yield,” is a number that tells us what the annual return, in percentage, is if we invest in a particular country’s government bond today. In the world of investing, we primarily focus on the U.S. Bond Yield because the U.S. is the world’s number one economic superpower. Therefore, when U.S. bond yields move, the bond yields of other countries tend to follow.
Why do Bond Yields Move?
In theory, each country’s Bond Yield should be equal to its policy interest rate, as both depositing money and investing in government bonds are considered “risk-free” investments.
However, this is not the case in the real world. This is because the bond market is traded constantly and we are in an era of very fast information. Therefore, whenever there is news or an issue that affects the forecast for future policy interest rates, investors will use that information to trade in the bond market. As a result, the current bond yield is equal to the “future policy interest rate” that most investors are “forecasting.”
This is an example from early August 2024. The U.S. policy interest rate was 5.5%, but the U.S. 2-year bond yield steadily dropped from 5.5% to 3.8% after the Federal Reserve began hinting at a potential rate cut in late 2024.
Therefore, once investors received this news, they reached a consensus that future policy rates would definitely fall and that they wouldn’t see such high interest rates again. This led to a large-scale, collective purchase of government bonds to lock in the high interest rates. When demand exceeded supply, the bond yields steadily decreased. This is why the Bond Yield adjusted downwards.
By now, you should have a good understanding of what a Bond Yield is and why it moves. The next question then is…
So, why does the stock market fall when bond yields rise, and why does it go up when bond yields fall?
It’s actually quite simple to understand. As mentioned earlier, bond yield represents the “expected future policy interest rate.” If bond yields rise, it means that deposit interest rates are likely to increase.
Everyone knows that depositing money is a risk-free investment. So, when the return on deposits is set to get higher, why would investors take on the risk of fighting for returns in the stock market? They can simply put their money in a savings account and get a higher, guaranteed return. This causes investors to reduce the proportion of stocks in their portfolios and increase their allocation to bonds or cash. Another reason is that when interest rates are expected to rise, companies in the stock market face higher financing costs, and their profits start to decline. This makes individual stocks less attractive.
Conversely, when bond yields fall, it means that the interest rates on future deposits will likely be lower. This prompts investors to adjust their portfolios and move their money into stocks, where they can expect higher returns. This influx of capital into the stock market helps to push the market higher.
A question many of you might have is: if we could accurately forecast future bond yields, wouldn’t that make us more effective investors in the stock market? The answer is yes.
However, forecasting bond yields is something that analysts around the world have gotten wrong time and time again. Even central banks worldwide can’t pinpoint the exact timing of their own interest rate hikes or cuts because it requires a vast amount of economic data, and that data is constantly changing. Therefore, I suggest that you don’t need to try and predict future bond yields, as it’s an impossible task to do with 100% accuracy.
What I’d like you to understand is that in the short term, the stock market can be volatile due to bond yields, but in the long run, whether the market goes up or down depends on corporate earnings. So, if you invest in a fund or in stocks of a country with a strong economic foundation, you shouldn’t have to worry when bond yields rise.
