Given the current uncertainties facing financial markets it is worth taking a longer-term view of the relationship between equity prices and short- and long-term bond yields. Going back over 25 years we see a similar pattern at critical junctures of rising short-term yields that eventually exceed long-term yields (i.e., inverted yield curve) followed by sharp drops in bond yields and then equity prices. This occurred in 2000 and 2007 signalling the end of the tech and housing bubbles, respectively. This time around, rising short-term yields have more recently been followed by falling long-term yields (see our previous feature “Leading Indicators”) again inverting the yield curve, indicating an expected economic slowdown, but with equity prices not much changed at this point.
If history is any guide, equity prices are poised to fall notwithstanding the absence of specific bubbles but rather a more generalized risky environment. Moreover, in light of the current unprecedented government debt levels, longer-term yields may bottom at these levels before rising significantly down the road – negatively impacting equities in the longer run.
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