Last week, equities tumbled as Treasury yields surged, but rising bond yields don’t always lead to long periods of under-performance for stocks.

What’s pivotal in this equation is for investors to assess why bond yields are rising in the first place, and whether the scenario boils down to one of two examples.

“The answer to that question depends on the reason why interest rates are rising. If it’s because real economic growth is picking up, that should be good for stocks through the earnings channel,” writes Talley Leger, Invesco senior investment strategist. “If it’s because inflation is getting out of control, that should be bad for stocks through the valuation channel. While I wouldn’t rule out an inflation ‘scare’ altogether, I believe such concerns may ultimately prove overblown. In my view, the selloff in stocks is simply a pause that refreshes, not a sinister change of trend.”

The Inflation Question

Yields on Treasury inflation-protected securities (TIPs) recently turned positive, confirming that inflation is something advisors and investors need to prepare for.

Some market participants are concerned that the Fed may have to change its interest rate policy sooner than expected. These doubts certainly contributed to last week’s equity pullback. Inflation fears are further reflected by a sharp rise in benchmark Treasury yields, which may be partially attributed to expectations for greater inflation.

Something else to consider: the impact of last year’s Federal Reserve interest rates may still not be fully reflected in the marketplace.

“In my opinion, the lagged impact of past interest rate cuts has yet to fully work its way through the system, with positive knock-on effects for stocks,” says Leger. “In fact, history argues that higher bond yields aren’t something we should seriously worry about until early 2023.”

While near-term inflationary risks linger, longer-term deflationary pressures aren’t abating.

“The bottom line is that I believe low interest rates for longer are the starting point for the ‘recovery’ trade that I expect to continue for some time,” notes Leger. “Historical recovery trends have typically included a modestly positively-sloped yield curve, flat to slightly weaker US dollar, stronger commodity prices, corporate bond outperformance relative to government bonds, and stock market outperformance relative to government bonds.”

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The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.