U.S. financial markets were battered at the end of last week because of a dramatic sell-off of Treasury bonds. The yield on 10-year bonds, which has been rising since May, neared the critical barrier of 5.25% on June 8 — the highest level in five years. Media reports suggest that turmoil in the bond market could continue this week, making investors anxious about whether interest rates might go up and bring to an end the period of cheap money that has buoyed up asset markets and also funded a world-wide boom in mergers. Why are bond yields so high? What do these developments mean for stocks and other asset classes? Knowledge at Wharton discussed these questions — and a few more — with Jeremy Siegel, a professor of finance at Wharton, and author of The Future for Investors.

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Knowledge at Wharton: You wrote in your newsletter at the end of last week that “The Wall Street Journal and most financial publications are wrong when they say that inflation is the reason why bond yields are rising.” What do you think are the real reasons?

Siegel: I believe that the real reason why bond yields are going up is because of an acceleration of worldwide economic growth. Interest rates are dependent on two factors: One is what we call the real interest rate, which is dependent on growth, and the other is inflation. And what we have seen over the last several weeks and continuing through today is a rise in that real interest rate — not the inflation premium, but the real interest rate — which I think is a signal of accelerating world growth.

Knowledge at Wharton: What will higher bond yields mean for stocks? Do you think that stocks are undervalued?

Siegel: This increase in interest rates is a very significant occurrence for all financial markets and asset markets. It’s going to give all of them trouble. I believe that stocks will pause in their upward movement, but perhaps will fair better than most of the other asset classes. In particular of course, bonds are going to be directly impacted by higher interest rates. They go down in price right with higher interest rates. But I also think that it will negatively impact real estate, and I think that the housing recovery is going to be stalled by the increase in rates. 

Knowledge at Wharton: You spoke about the impact on real estate. What do you think will happen in the mortgage market, and will the housing market and the commercial real estate market be affected in the same way?

Siegel: Commercial and industrial real estate, I think, will be less affected because the acceleration of economic growth will bring about more demand for real estate. I still think that the effects will be negative there. It perhaps will be most serious in the owner-occupied residential housing industry, which is not as strongly affected by swings in the world economy. Clearly mortgage rates are rising. Fixed interest rates, which had stayed low for so long, are going to get more expensive — and that’s definitely going to put a pause in the real estate market.

Knowledge at Wharton: A report in The Economist suggests that the establishment of sovereign wealth funds in China and elsewhere will “prompt a shift from Treasury bonds to more exciting asset classes.” What are sovereign wealth funds, and do you think that this might happen?

Siegel:  Actually, I think that the bond market is getting kind of exciting now — by going down so much. (Laughs.) Really, right now it’s past 5.25% — just this afternoon it’s going up around the world, which means that bonds are beginning to look attractive. Certainly they’re not as attractive as stocks; but the gap between what you can get on bonds today — and now that corporate bonds are going to be between 5.5 and 6, and stocks are probably somewhere between 8 to 9, maybe 9.5 depending on how you look at it — that’s narrow. So, what we call the “premium” that you get on stocks, relative to bonds, is going down. In the big picture, I don’t think that stocks are overvalued. But I also think that with this tremendous rise in bond yields, we are approaching a fair market value for stocks, after being undervalued for many years.

Knowledge at Wharton: Apart from stocks and bonds, I wonder if you could talk a little bit about what will be the impact on other asset classes — for example, gold.

Siegel: Well, as I mentioned, clearly bonds are directly affected. I think actually that risk premiums on bonds may also be adversely affected — which means that the lower-grade bonds may be hit in some cases more than the higher-grade bonds. I think that residential real estate will be negatively affected — perhaps significantly — and industrial and commercial less so.

Commodities are a difficult one to analyze. The greater economic activity is a positive boost. But don’t forget, when people hold commodities, they give up interest rates. And if interest rates are going up, that becomes a more costly hold. We’ve seen some declines in gold recently and I think they can be attributed to the rise in interest rates. But oil and many of the other sensitive commodities are holding at the present time. They haven’t been negatively affected, but I wouldn’t be surprised to see some downward movement in their price, too.

Knowledge at Wharton: Meanwhile, the dollar has been doing well. Will it continue to do so?

Siegel: Well, we’ve had a recovery. The dollar has been in a downturn for a couple of years and now. With this rise in interest rates on Treasury bonds, it becomes a little bit more attractive to hold in the U.S. Also, another reason is that if we take a look at the federal funds futures market, all expectation of a drop in federal reserve rates is now gone. And that was a major reason why a lot of foreign exchange traders were selling the dollar, because they thought that the Fed was going to lower rates to a slowing economy. That’s been wiped out; so you see movement back into the dollar, and $1 going up to $1.32 with the euro.

I wouldn’t be surprised to see some more strength in the dollar. Also, you had mentioned the question of sovereign wealth funds: These are huge funds of cash that central banks and treasuries around the world have collected over the years, because of their support of the currency. There’s a lot of talk of them diversifying into other assets. The interesting thing now is that with Treasury bond prices down and interest rates up, there’s actually less of an incentive for them to move into other asset classes than before. They’re actually getting a better return. So I don’t think that this rise in bond yields will accelerate the movement of sovereign wealth funds into other asset classes — it may actually retard that movement.  

Knowledge at Wharton: Considering what’s happening in the bond markets and based on what you just said about the Fed, do you think that there is any chance that there may be any upward movement in interest rates? Or, does the fact that the bond markets have already seen an increase in real interest rates already take care of the problem? 

Siegel: Well, you’re perfectly right — the rise in the long-term rates is helping the Fed restrain inflation and slow the economy. We’re getting help from the bond market. So, in a way, I think that there is almost less reason now for the Fed to raise the interest rate. On the other side, the fear of a greatly slowing economy that had dominated the economic headlines a couple months ago, with the sub-prime mortgage crisis — that has just about faded. 

World growth is very, very strong. So we’re not going to get that downward movement. I think that the Fed is going to hold. Inflation, interestingly enough, is not getting worse, and if the dollar strengthens a little and we see oil and gold go down, that might also calm fears. So, right now, there is no increase that I see. I see the Fed again on hold, and it could be for quite a few months.

Knowledge at Wharton: Some market observers believe that turbulence in the bond markets represents a turning point in the liquidity cycle. Do you agree?

Siegel: Some people are pointing out that the downtrend of interest rates that they have been tracking for some 25 or 30 years is now over. It’s broken above that downtrend and I agree. Interest rates should never have been as low as they were back in 2003 [down to 3%], and we’re coming back to more normal rates. One should stress the fact that this rise in interest rates is actually coming back to more normal levels; it’s high in relation to what we’ve had in the last two, three or four years — it is not high in a long-term historical perspective.

Knowledge at Wharton: Let’s end with the usual question: Considering everything that’s going on, what is the best strategy for investors in the coming weeks?

Siegel: Well, you know, with rising interest rates nothing is pretty for a while. You could get into cash, but really that would be playing the market. I would say that REITs [Real Estate Investment Trusts] might have a little difficulty; low-grade bonds might have a little bit of difficulty. Basically, I would stay diversified in stocks. Again, they may stumble a little bit, but I don’t think at all they’ll experience a severe correction. And again, if my hypothesis is right — that it’s stronger growth — those stronger profits are going to offset a lot of the higher interest rates that usually give stock prices problems.