It is summer time – but the living is looking less easy for investors in global markets. In recent weeks, bond markets have sold off heavily, with yields in several leading markets rising sharply.

The sell-off, prompted in the US by stronger-than-expected economic growth and in Europe by worries about inflation, is now having a ripple effect on equity markets as rising yields unnerve investors.

As bond yields rise, equities traditionally fall on concern that higher interest costs will hit corporate profitability, slow the economy and damp takeover activity.

In addition, this time around, some investors appear to be worried that higher rates will make the so-called carry trade marginally less attractive. This trade – widely believed to have fuelled gains in equity and commodity markets – involves borrowing in currencies with low interest rates to invest in higher yielding assets elsewhere.

The shift in bond markets marks a decisive shift in sentiment. Since last summer, US bond investors have worked on the assumption that the next move in the benchmark overnight Fed funds rate would be down. Consequently US Treasuries, which set the tone for the rest of the market, were trading at yields well below the prevailing Fed funds rate of 5.25 per cent. But last week the US published its May employment report which, in line with most other recent data releases, was stronger than forecast.

This has prompted economists to argue that the US consumer may well be able to weather any further slide in housing prices as well as high petrol prices. This, in turn, potentially vindicates the Fed’s year-old wait-and-see approach on monetary policy.

As a result, several influential economists, including those at Merrill Lynch and Goldman Sachs, have this week abandoned their long-standing forecasts of rate cuts for this year. “People have thrown in the towel over rate cuts,” said Richard Gilhooly, senior fixed income strategist at BNP Paribas. This has pushed the yield on the 10-year bond to near 5 per cent, its highest level in 10 months, although still below the Fed’s overnight rate.

This shift does not yet equate to expectations of an imminent rise in rates. Three-month eurodollar interest rate futures now imply a stable outlook for the next few years, from a projected low of 5.26 per cent in mid to late 2008, future three-month rates are seen rising to a peak of 5.49 per cent by September 2011.

“Bond yields have been rising as people have become more confident about the economic outlook,” said Dominic Konstam, head of interest rate strategy at Credit Suisse. “Yields are in the last throes of pricing out an easing, and we still have some way to go before the market indicates the Fed is poised to raise rates.”

However, in Europe there are already expectations that more rate rises are on the cards. That helped push 10-year German Bund yields through the psychologically significant level of 4.5 percent this week – their highest since November 2002 – although they fell back on Wednesday in the wake of the monthly monetary policy statement from the European Central Bank.

Even in Japan, which has long had rock-bottom government bond yields, sentiment is shifting: the two-year JGB yield, for example, on Wednesday rose to 1.005 per cent, marking the first time it has been above 1 per cent since March 2006 when the Bank of Japan ended its quantitative easing policy.

Until this week, rising bond yields appeared to be having relatively little impact on equity markets. But on Wednesday, Europe’s FTSE-Eurofirst 300 fell for a third day in a row. A similar pattern can also be seen in the US, where the main equity indices are down more than 1 per cent for the week led by utility stocks, which tend to be particularly sensitive to moves in interest rates.

Some analysts regard this as simply a short-term reversal that was inevitable after the recent, remarkable bull run in global equities. They also argue that the prospect of a healthier economy amid strong buy-out and merger activity can compensate for the lack of a rate cut this year – meaning that equity markets could continue to shrug off rising bond yields.

However, other observers are worried that bond yields could keep rising because inflation fails to moderate. A troublesome rise in first quarter US unit labour costs on Wednesday sparked further selling in stocks.

Ashraf Laidi, analyst at CMC, added that Wednesday’s widely anticipated ECB rate hike was “the latest catalyst in sustaining the multi-month [rise] in global bond yields, which will increasingly weigh on equities and risk appetite.”

He saw parallels between the current market patterns and “developments prior to the equity corrections of May-June 2006 and February-March 2007”.

There is also the possibility that in the US at least, recent confidence in the economy could be misplaced.

Speaking this week, Ben Bernanke, Fed chairman, expressed concern that housing ”appears likely to remain a drag on economic growth for somewhat longer than previously expected.”

The recent rise in bond yields makes home loans that re-set over the next year more expensive, and is thus acting as a form of Fed tightening. Mr Gilhooly at BNP Paribas said: “The Fed cannot raise rates, because mortgage resets already represent a significant tightening in policy and core inflation has moderated.”

Another crucial factor for global markets could be the sustainability of low corporate funding costs, particularly for riskier leveraged buy-outs. These have helped to support the LBO wave and, in turn, equity prices.

The cost of raising junk-rated debt has risen slightly in the US over the last year, while in Europe, leveraged finance costs have continued to fall, thus moving in the opposite direction to central bank rates (see chart).

However, the sheer weight of money swirling around global markets at present, makes most analysts wary of predicting any serious change in corporate funding costs soon.

Copyright The Financial Times Limited 2018. All rights reserved.

Comments have not been enabled for this article.