Here's What Scared the Stock Market This Week

Stock markets continued to swirl on Friday as market participants tried to figure out which competing cross-currents would end up winning out over others. In the end, the Dow Jones Industrial Average (^DJI 0.06%) finished almost flat, with the S&P 500 (^GSPC -0.22%) moving lower and the Nasdaq Composite (^IXIC -0.52%) picking up a tiny amount.

Data source: Yahoo! Finance.

Most investors have focused squarely on the stock market lately, especially given how major benchmarks have climbed to all-time highs on many occasions in recent months. However, changes in the bond market are threatening to have an impact on stocks, and some believe that the moves in bonds are already changing the environment for investors in a way that could prove problematic for the stock market going forward.

What's happening in bonds?

One of the foundations for the rise in stock prices has been that investors have few good alternatives. Interest rates have been stuck at rock-bottom levels for years, making bonds a less than ideal investment. The Federal Reserve has signaled that it won't be in any hurry to allow short-term rates to rise in the near future, and it is likely to continue the efforts it has made to keep longer-term rates down as well.

However, bond investors seem to have lost confidence in the Fed's resolve in continuing to support low rates. In less than a month, rates on the 30-year Treasury bond  have gone from 1.78% to 2.14%. That rate is up nearly a full percentage point just since last July.

Image source: Getty Images.

Many investors pay closer attention to the 10-year Treasury bond, and it's showing similar behavior. Ten-year rates briefly sank to below 0.4% during the depths of the coronavirus bear market, but the yield has subsequently risen to 1.35%.

A big deal for bond fund holders

Those rises might not seem like that big a deal. After all, rates were routinely in the 4% to 8% range in the 1990s, and there was a huge bull market in stocks during that period. Similarly, stocks did well in the mid-2000s even with bond yields of 3.5% to 5% for the 10-year Treasury.

However, the impact on bond market investors has been substantial. Because yields are so low, an increase of even a small amount can have a disproportionately large impact on prices. The iShares 20+ Year Treasury Bond ETF (TLT -0.50%) is down 9% in less than two months since the beginning of 2021. The bond ETF has lost 16% of its value since last summer.

Losses for more diversified bond funds haven't been as bad but have still caused some unexpected pain. The Vanguard Total Bond Market ETF (BND -0.27%) is down about 2% year to date and has fallen almost twice that since late July.

What it means for stocks

At least until now, the rise in bond yields hasn't had any substantial impact on the stock market. However, at some point, higher rates would allow savers who've had to resort to riskier stock investments for income to return to more conservative plays. That could take away a key source of demand for stocks, potentially weighing on future market gains.

However, one thing to remember is that most investors right now are focused not on income but rather on growth. Bonds will never offer true growth opportunities, and so even a big spike in bond yields might not cause much of a reversal in many of the big-name stocks that have played such a key role in sending markets to all-time highs.