FxWirePro: Impact of shrinking gap between S&P 500 dividend yields and U.S. 10-year Treasury yields

The yields on 10-year Treasury surged to highest in 2016 after Republican candidate Donald Trump won the United States 2016 presidential election. Also, backed by Trump’s fiscal policies, Treasuries saw a massive sell-off post-election result, sending 10-year yields higher by 50 basis points.

Fundamentally, bond yields are directly proportional to dividend yields on stocks and the latter is generally expected to be higher than the former, as investors need a higher return on owning riskier stocks. Therefore, to see a rise in stock yields, either dividend needs to go up, or stocks have to decline to push the dividend yields.

In the aftermath of the U.S. election result, bond yields surged to the same level of riskier S&P 500 dividend yields. Due to this, safe-haven investors can reap the same yields as they would have from riskier stocks.

It is worth noting that the ongoing sell-off in U.S. Government bonds is only because of Donald Trump’s fiscal spending appeal, which is expected to be financed from government borrowing and not because of growth in the U.S. economy.

If Trump successfully implements his fiscal plan, consumer inflation will surely rise, giving the Federal Reserve wider space for an interest rate hike. Thereby, rising Fed fund rate will increase the cost of borrowing. Also, increase in government debt will raise the risk of potential default.

Meanwhile, such a situation would usher in a difficult situation for the U.S. economy, creating high levels of government debt. U.S. bond yields are used to finance consumer, corporate and real estate loans. If yields continue to rise, it will squeeze the cash flow of debtors, pinching the economy with high-interest rates.