SINGAPORE (Feb 22): Investors shouldn't worry that a faster pace of rate hikes by the US Fed will drive up yields which could then negatively impact stock markets, says Bank of Singapore.

The current equities correction is closely linked with heightened inflation expectations, which also drove a surge in the US 10-year Treasury yield from 2.4% to 2.9% year to date.

The fear is that this in turn could impact accommodative financial conditions that have been supportive of the market so far.

However, history has shown that equities generally rose over the last three periods when the Fed hiked rates towards neutral levels, says Eli Lee, head of investment strategy for Bank of Singapore.

In fact, an analysis of bond yields and equity returns over the last 20 years shows a positive correlation: Equities tend to rise when bond yields move up.

The return of inflation to normal levels is typically a healthy consequence of rising growth and robust demand-side activity, as the economy nears full employment and capacity.

To counter-balance the risks of over-heating in this situation, the Fed increases interest rates towards neutral levels as a result.

This more mature stage of the economic cycle – which we are now in – is still a healthy one for equities, according to Lee.

"However, because there is less room for policy error and because it is less ideal than the earlier 'Goldilocks' phase of accelerating growth and subdued inflation seen in 2017, we can expect markedly higher market volatility ahead," says the analyst.

The current correction was due a minor shock experienced by the market as it rapidly reset inflation expectations higher, while recognising the economy is in a more mature stage of the cycle than thought.

That led to a negative correlation between equity prices and bond yields.

"As the equities decline took place over the last two weeks, bond yields increased alongside higher inflation expectations," says Lee.

However, a sustained period of such negative correlation will be unusual at this stage of the economic cycle – especially when short-term rates have not yet reached neutral levels of 2.5%-3.0%, says Lee.

He believes a positive correlation between equity prices and bond yields is likely to resume when conditions normalise over time, particularly as the overall outlook for economic growth and corporate earnings remains firm.

One tail risk though is that a continued surge in bond yields – at the pace seen over 2018 to date – could ultimately have a disruptive impact on underlying economic and market fundamentals. Of course, higher yields directly impact borrowing costs for consumers, corporates and sovereigns, and also affect the prices of assets that reflect discounted future cash flows.

"In our view, an increase at the same pace is not likely," says Lee.

First, while inflation is likely to trend steadily higher, a “take-off” scenario is improbable.

Second, bond yields are already reflecting more realistic expectations and we note that the reaction of the 10-year Treasury yield after the last CPI beat on Feb 14 was quite controlled, while the equities market also rose on that day.

"Our base case is for the US 10-year Treasury yield to increase gradually by about 35 basis points over the next 12 months to 3.25%," says Lee.

Under the bank's base case scenario, the long-term outlook for equities remains positive, but investors are urged to prepare for significantly higher volatility ahead.

"We have an overweight position on equities under our asset allocation strategy, and we prefer to take a barbell approach through exposure to the cyclical sectors (prefer Financials and Consumer Discretionary) and defensive sectors (prefer Healthcare and Telecom)," says Lee.

Regionally, the bank has an overweight rating on European equities, which are supported by solid EU growth and an overall rotation towards relative value.

Rising bond yields will also benefit the European banking sector which is a significant component of the European market.