Here's how long it has taken in the past for stocks to peak once bond yields start rising

(Photo by Jonathan Ferrey/Getty Images)

With a surge in bond yields the catalyst for the mini-riot that started last Friday on Wall Street, the interplay between yields and stocks is right at the heart of what happens next in financial markets.

Research from Capital Economics (CE) offers some context.

The combination of steady growth and low inflation has provided a great backdrop for US stocks to rally to all-time highs.

But the threat of higher bond yields still lingers, as evidenced by this week’s stock market selloff.

Here’s economist John Higgins on CE’s outlook:

We have been warning for a long time that investors have been too complacent in anticipating continued strong growth and low inflation alongside a gentle pace of monetary tightening.

Our expectation is that unbridled optimism will give way to growing pessimism, as it becomes clear that the US economy will slow in response to tighter Fed policy and fading fiscal stimulus.

If that turns out to be the case and more volatility is on the way, Higgins provided a table which shows a historical timeline for key changes in different asset classes.

It summarises the last seven US recessions by highlighting three key points in the cycle:

1. The date when corporate bond yields reach their low;
2. The date when equity prices peak; and
3. The date when the economy tipped into recession:

The data shows that changes in the economic cycle always have always started with the bond market.

In the most recent recession which culminated in the 2008 global financial crisis, the yield on Baa-rated US corporate bonds hit a low in December 2006.

Stocks then peaked in October 2007, before the economy fell into recession in December that year.

So based on that historical reference, it suggests that broader support for equities should remain in place — at least for most of this year.

“The median gap between the peaks in the two markets was ten months,” Higgins said.

“In this cycle, we suspect that the low point in the corporate bond yield, which is now around 4.4%, was reached in mid-December, when it was 4.15%. If so, it would be unusual – albeit not unprecedented – if the equity market had already peaked less than two months later.”

“A peak this October would instead be par for the course. That would tie in with our view that the US economy will be showing signs of slowing by then.”

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