Why Higher US Yields Should Cheer Investors

Traders work in the S&P 500 options pit at the Chicago Board Options Exchange.
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Traders work in the S&P 500 options pit at the Chicago Board Options Exchange.

Rising U.S. bond yields should embolden, not spook, investors as they reflect improving growth and increase the allure of assets that most benefit from an economic upturn.

The violent market reaction to the prospect of an eventual end to the Federal Reserve's money printing led some to think that the central bank's stimulus was the only thing keeping markets and economies afloat.

But the shifts in bond pricing reveal a repositioning for better economic times ahead. In order to benefit from this, investors may switch from buying securities that give a stable income in tough times into assets that will ride an economic pick-up.

The Fed's policy shift triggered a sell-off in government bonds and pushed up the yield on U.S. Treasurys—the benchmark against which all other assets are measured.

(Read More: US Yields Spike After Strong Jobs Report)

However, bond markets are now factoring in a rosier economic picture judging from changes in the shape of the yield curve—the illustration of how much investors demand to lend money over short and longer periods.

"A steepening yield curve in almost every occasion is a response to improved economic times. Effectively the fixed income market is beginning to discount a strong economic upturn in the next half a year," said Mike Howell, managing director of CrossBorder Capital.

Benchmark U.S. Treasury yields hit a 22-month high last week after Fed Chairman Ben Bernanke suggested the central bank would scale back its bond buying.

The yield curve steepened as a result, with the gap between two-year and 10-year yields reaching 222 basis points compared to 169 basis point before Bernanke's intervention.

(Read More: Expected Rotation Out of Bonds Rattles Hedge Funds)

This adjustment should eventually filter into other asset classes as they price in a better economic backdrop.

A move higher in real interest rates—nominal rates minus inflation—also reflects expectations that companies will start borrowing and spending again to expand their business, having hoarded cash after the financial crisis.

"The change in real interest rates means big capital spending is coming back and return on capital is beginning to increase again," Howell said.

Higher inflation-adjusted rates also point to a better rate of return on investment, another indicator of improving economic fortunes.

Howell expects a rotation into stocks more geared to a healthier economy.

Income Mania Over?

Capital is already flowing out of low-yielding bonds. Pimco Total Return fund, the world's largest bond fund, suffered record outflows of $9.6 billion in June, in a second straight month of withdrawals.

Mutual and exchange-traded bond funds lost a record $79.8 billion in June, according to TrimTabs Investment Research.

Another factor bolstering the growth theme is liquidity, which is likely to remain very loose even if the Fed reduces its $85 billion monthly bond-buying program.

And central banks elsewhere are keeping the stimulus taps firmly open.

The European Central Bank has suggested it may cut interest rates further, while the Bank of England warned that markets were being too quick to bet on higher borrowing costs. And this is before you include the Bank of Japan, which stands ready to pump more money into the economy if needed on top of its existing $1.4 trillion program.

(Read More: July 4: Independence Day for Europe's Central Banks?)

Rabobank estimates that the Fed's easing program is equivalent in terms of its impact on long-term rates to a rate cut of almost 10 basis points per month.

Even if the Fed only bought $65 billion of assets a month, this would still mean a policy move equivalent to quarter point rate reduction every 3-1/3 months.

"So the Fed would continue giving the economy and the markets a new monetary impulse each month. The pace of purchases can be reduced even further but that would still be monetary loosening," the bank said in a note to clients.

Investors are already beginning to move away from defensive stocks—such as utilities and basic food suppliers—as economic prospects brighten. Their lead over securities linked to growth peaked in mid-April.

"The whole theme for looking for income or yields was the sweet spot for the first half of the year. The theme is in its last phase," said Valentijn van Nieuwenhuijzen, head of multi-asset strategy at ING Investment Management.

He said growth-oriented sectors such as consumer staples and IT would outperform going forward.

"In a world where central banks are contemplating, on the back of strong data, to gradually lower easing, the justification for (the previous) investment approach is becoming less obvious."