CHART OF THE DAY: If We Want Stocks To Keep Surging, Government Bond Yields Need To Rise

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Stocks have staged a remarkable rally with no major corrections.

In a new research note to clients, Citi global equity strategist Robert Buckland discusses what happens after 20 per cent rallies in the stock markets.  Specifically, he looks for what the key drivers were that extended previous 20% rallies.

“Our study of previous +20% rallies shows that for equities to fly there needs to be a combination of (1) lower than average starting valuations, (2) double digit EPS growth, (3) rising PMIs, (4) higher US government bond yields and, (5) sustained flows into equities,” wrote Buckland.

Most of those points may seem pretty obvious.  But the point about rising government bond yields isn’t always intuitive.

Here’s Buckland on bond yields (emphasis ours):

Bond market confirmation
Rising profits and improving economic activity are often not enough for market momentum to be sustained. Often the improving environment for equities needs to be mirrored by a deterioration for fixed income investors. We find the first 20% gain in markets is often accompanied with stable bond yields (we use US treasuries). But for markets to make double digit gains from here we usually need to see core government bonds yields rise by 50 basis points or more. They tend to decline by 80 basis points when markets fall from here (Figure 8).

We believe rising bond yields help equity markets in two ways. First, higher yields drive a steeper yield curve which has previously been a robust forward indicator of future economic and profits growth. While QE has weakened the signaling effect of the yield curve, there are still many who take their guide for economic activity and equities from the bond market. Second, falling bond prices encourage a shift of money back into equities, as investors chase returns. In the case of pension funds, higher yields, in theory, should reduce the present value of future liabilities and free up more cash to allocate to riskier assets. This leads us to the next element investors should consider at this stage of a bull market.

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