After many false promises and one false start, it is becoming evident that 2017 will be the year the Federal Reserve finally begins down the road towards interest rate normalization. Therefore, it is likely that Ms. Yellen will cause bond yields to rise this year on the short-end of the yield curve. In addition, soaring debt and deficits, along with the lack of central bank bond-buying, should send long-term rates much higher as well.
Wall Street soothsayers, who viewed every Fed rate cut as a buying opportunity for stocks, are now busily assuring investors that the potential dramatic and protracted move higher in bond yields will be bullish for stocks as well.
Their theory holds that the price of stocks and bonds are negatively correlated, as one moves up the other moves down. Hence, the nirvana of a safely balanced portfolio is achieved by simply owning a fairly even distribution of both. Therefore, according to Wall Street, the end of the thirty-five-year bull market in bonds will be a welcomed event for equities. This myth has a name, and it's known as "the great rotation from bonds into stocks."
The concept suggests that the investible market works like a balanced fund; as money moves out of bonds, it moves into stocks. And of course, you could cherry pick cycles over the past few decades that would provide support for this opinion. For instance, the biggest rise in interest rates (fall in price) was from February 1978 to November 1980. During this time the yield on the Ten-Year Treasury rose from 8.04% to 12.80%, while stock market averages enjoyed a healthy gain.
But when you take a step further back and look at the correlation between stock prices and bond yields since Nixon broke the gold window in 1971, you quickly realize that there is no such positive relationship. In fact, most of the time stock prices and bond yields move in the opposite direction. As bond yields increased (prices down) during the stagflation of the 70's, stock prices went lower or simply stagnated. Then, after Fed Chair Paul Volcker vanquished inflation in the early '80s, bond yields fell (prices increased) and stock prices went along for the ride.
This relationship makes perfect sense. An unstable economic environment of rising inflation and rising borrowing costs causes equities to suffer. Conversely, a healthy economic environment of steady growth and low inflation is beneficial for stocks.