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The recent rise in bond yields and accompanying volatility in markets could be masking a significant rotation occurring underneath the surface. Anthony Okolie speaks with Jimmy Xu, Portfolio Manager, TD Asset Management, about what these changes are signalling about equity market risks.
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- Well, bonds have been out of favor for many investors as rock-bottom rates have made them unattractive relative to equities. But the 10-year US treasury yield has risen sharply in recent months. And equity market volatility has also spiked. Jimmy, you brought a chart with you today. Can you walk us through it and explain to us exactly what we're seeing?
- Sure. Hi, Anthony. Absolutely. The chart that we have put on the screen shows the US 10-year yield in green against the-- plotted against the volatility index in blue. So what this chart is showing is that as the US 10-year bond yield has been rising over the last month, we're seeing a pickup in equity volatility.
So what's happening in fixed income has a flow-through effect into the equities market. And why this is happening is actually quite intuitive. If you think about it, when you buy equities, you're effectively buying the future cash flows or earnings of the company discounted back to today's value. And the 10-year yield is really important in that process because it's often used-- the interest rate used to discount that cash flow back.
So when the 10-year yield rises, those future cash flows will be worth less. So what the market is concerned about is that if the 10-year bond yields rise too quickly, that would result in a sell-off in equities market. And this is why the 10-year bond yield has resulted in a sharp increase in volatility.
- Yeah, no, that really highlights why it's so important that people pay attention to that 10-year treasury yield. Now, even though volatility is somewhat muted versus other periods, there's still a lot going on when it comes to market activity. Correct?
- Yeah, absolutely. When you look at the volatility index now, it seems like it's fairly tame compared to previous cycles where rates have backed up very quickly like in 2018 and during the taper tantrum. But I think that's somewhat misleading because it's hiding some of the fairly violent sectoral cases that we're seeing.
So for example, US regional banks, which benefits from a higher interest rate environment because they can earn higher net interest margins, have outperformed technology stocks, which benefits from a lower rate environment, by more than 30% this year. And that's a staggering amount considering we're just a little over two months into this year. So the impact on interest rates, despite the fact that on the surface remain somewhat calm, but underneath, a lot of things are happening.
- So what should investors take away from all of this?
- Yeah, I think it's really important to recognize that we're entering to a part of the market cycle where the underlying macro environment is shifting very, very rapidly. I think from an invest perspective, they have to recognize that the portfolio or what worked last year is probably not the optimal portfolio to hold going to this year when the economy is recovering from the COVID crisis.
So I think it's really important at this time to utilize active management to separate the winners from the losers so that we can capture those dynamics and make money and not leave money on the table. Because right now, the difference between the winners and the losers are pretty massive.
- And certainly, this saga is going to continue as well. And we'll continue to monitor it. Jimmy, thank you very much for joining us today.
- My pleasure.
[MUSIC PLAYING]
- Sure. Hi, Anthony. Absolutely. The chart that we have put on the screen shows the US 10-year yield in green against the-- plotted against the volatility index in blue. So what this chart is showing is that as the US 10-year bond yield has been rising over the last month, we're seeing a pickup in equity volatility.
So what's happening in fixed income has a flow-through effect into the equities market. And why this is happening is actually quite intuitive. If you think about it, when you buy equities, you're effectively buying the future cash flows or earnings of the company discounted back to today's value. And the 10-year yield is really important in that process because it's often used-- the interest rate used to discount that cash flow back.
So when the 10-year yield rises, those future cash flows will be worth less. So what the market is concerned about is that if the 10-year bond yields rise too quickly, that would result in a sell-off in equities market. And this is why the 10-year bond yield has resulted in a sharp increase in volatility.
- Yeah, no, that really highlights why it's so important that people pay attention to that 10-year treasury yield. Now, even though volatility is somewhat muted versus other periods, there's still a lot going on when it comes to market activity. Correct?
- Yeah, absolutely. When you look at the volatility index now, it seems like it's fairly tame compared to previous cycles where rates have backed up very quickly like in 2018 and during the taper tantrum. But I think that's somewhat misleading because it's hiding some of the fairly violent sectoral cases that we're seeing.
So for example, US regional banks, which benefits from a higher interest rate environment because they can earn higher net interest margins, have outperformed technology stocks, which benefits from a lower rate environment, by more than 30% this year. And that's a staggering amount considering we're just a little over two months into this year. So the impact on interest rates, despite the fact that on the surface remain somewhat calm, but underneath, a lot of things are happening.
- So what should investors take away from all of this?
- Yeah, I think it's really important to recognize that we're entering to a part of the market cycle where the underlying macro environment is shifting very, very rapidly. I think from an invest perspective, they have to recognize that the portfolio or what worked last year is probably not the optimal portfolio to hold going to this year when the economy is recovering from the COVID crisis.
So I think it's really important at this time to utilize active management to separate the winners from the losers so that we can capture those dynamics and make money and not leave money on the table. Because right now, the difference between the winners and the losers are pretty massive.
- And certainly, this saga is going to continue as well. And we'll continue to monitor it. Jimmy, thank you very much for joining us today.
- My pleasure.
[MUSIC PLAYING]
