There was a dramatic shift in mood in markets this week. Weak US economic news and some poor corporate results led to a heavy fall in stocks and a big bond market rally that pushed yields sharply lower.
That was an ironic development given that stock market bulls have long argued that low government bond yields justified higher equity valuations. Understanding the future relationship between equities and bonds will be vital for long-term investors.
Low bond yields were perceived to be good for equities for two reasons. First, and most obviously, the bulls argued low yields meant that cash and bonds were fundamentally unattractive, pushing investors towards risky assets in search of higher returns. That argument is less convincing now that both short rates and bond yields have risen strongly since 2021, while inflation has dropped, meaning that investors in cash and bonds can earn positive real returns.