What does the chart show?

The chart shows the US 10 year government yield (red line) and the share price performance of the MSCI World Financials Index relative to the MSCI World Index (blue line). An upward sloping blue line indicates the MSCI World Financials Index is outperforming the broader MSCI World Index, whereas a downward sloping line means it is underperforming. Since the beginning of the year, the performance of the MSCI World Financials Index has bettered the broader index.  The yield on the benchmark 10-year Treasury bond has climbed for seven consecutive days to 1.77%, now above the highs of last year. Through time there has been a fairly tight relationship between the two. Higher yields have been positive for financial equities whilst lower yields are often associated with underperformance.

Why is this important?

Minutes from December’s US Federal Reserve meeting were released last week which pointed to the central bank potentially raising interest rates and shrinking their balance sheet faster than previously anticipated, in response to consumer prices rising to multi-decade highs and the labour market showing strong signs of recovery. This triggered a sell-off in US government bonds in anticipation of tighter policy from the Fed which coincided with a sharp increase in bond yields. We saw this feed through into the equity market. Higher bond yields have a greater negative impact on growth stocks than value names, as the interest rate used to discount their higher future earnings increases, meaning the present value of those earnings (in theory, the share price) decreases. This has hit tech stocks, whose valuations are better supported in a lower interest rate environment. Financial stocks, on the other hand, can benefit from increasing interest rates through higher net interest income (the difference between income earned and income paid out). Furthermore, banks have started to release loan loss provisions set aside earlier in the pandemic and more of this is expected which should be supportive for earnings. So far this year we have seen financials outperform the broader equity market by over 5%.