Will Rising Bond Rates Threaten the Dow?

Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.

The stock market has performed well so far Friday, as solid figures from the University of Michigan's preliminary consumer sentiment index for February suggested that cold weather and questions about economic strength aren't dampening everyday Americans' views of the economy. That news helped push the Dow Jones Industrials (DJINDICES: ^DJI  ) up 75 points by 12:30 EST. But it also led to falling bond prices and higher yields, as bond-market investors ponder whether the same economic concerns that sent the Dow to a minor correction could eventually cause bonds to give up their surprising gains for the year so far -- and cause direct problems for Dow Jones components Goldman Sachs (NYSE: GS  ) and JPMorgan Chase (NYSE: JPM  ) .


Source: National Archives and Records Administration.

The state of the bond market
This year's gains in the bond market have shocked investors even more than the Dow's decline. After such a strong move in 2013, the Dow was long overdue for some sort of correction, and investors have taken the drop in the average in stride. But the general belief among bond investors was that the Federal Reserve's gradual withdrawal from bond-buying activity under quantitative easing would inevitably lead to higher rates, with the Fed's goal to keep the rise slow and steady to avoid a bond-market rout. Few investors foresaw the potential for an actual drop in rates.

But it was the cause of the Dow's January decline that likely led investors to jump back into the bond market. Sluggishness in the U.S. economy and threats of economic trouble overseas were enough to lead investors back to the safe haven of Treasuries, leading to gains of almost 8% for the iShares 20+ Year Treasury ETF (NYSEMKT: TLT  ) by the time the Dow hit bottom on the first trading session of February. Other types of bonds didn't post equally impressive gains, but most did climb somewhat.

As the Dow has recovered over the past couple of weeks, though, bonds have started to give up some of their gains. Initial hopes that the Fed might slow down on its quantitative-easing tapering process have given way to the reality that new Chairwoman Janet Yellen is likely to keep policy moves steady for the foreseeable future. Unless the problems in the U.S. economy turn out to be more than weather-related singular events and spread to create overall long-term weakness for future growth, the central bank doesn't appear likely to prevent at least gradual rises in rates.

Should Dow Jones investors care?
The obvious question is whether rising bond yields will keep being good for stocks. Until now, stock and bond prices have moved in opposite directions in large part because money has flowed between the two asset classes as alternatives for the other. Investors see stocks as a place to invest when they're willing to take risk, while bonds remain the lower-risk bet.

What stock investors ignore, though, is that bond yields can have negative impacts on stocks. In particular, Goldman Sachs, JPMorgan Chase, and other financial stocks have a direct interest in making sure that the bond market performs well. Goldman gets much of its business from bond underwriting and trading activity, while JPMorgan and many other banks maintain extensive portfolios of bonds on their balance sheets. As we saw in mid-2013 when the Fed started discussing the end of quantitative easing, these and other stocks, such as homebuilders, could eventually start reacting negatively if bond rates rise. So before you celebrate higher rates as a necessary price for Dow gains, keep in mind that rates that are too high could eventually hurt stocks as well.

Don't be afraid to invest
No matter what happens to bonds, though, getting out of stocks entirely isn't a smart move. Those who've stayed out of the market in recent years have missed out on huge gains and put their financial futures in jeopardy. In our brand-new special report, "Your Essential Guide to Start Investing Today," The Motley Fool's personal finance experts show you why investing is so important and what you need to do to get started. Click here to get your copy today -- it's absolutely free.


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