World stock markets in retreat under pressure from bond rout by Geoffrey Smith @FortuneMagazine May 7, 2015, 7:05 AM EDT E-mail Tweet Facebook Google Plus Linkedin Share icons The world’s stock markets have taken a battering Thursday, succumbing to the fear that has grabbed bond markets in the last week on the realization that there was little or no room for them to go any higher. By lunchtime in Europe, most markets had started to stabilize or even recover, but a combination of fears over valuations, interest rates and oil prices are keeping them firmly in negative territory. Germany’s DAX was down 0.3%, while the UK FTSE-100 was down 1.3% The dollar, meanwhile, is hovering around a 10-week low against the euro as the market braces for the May employment report on Friday, amid speculation that the pace of job growth is falling sharply. Rising long-term interest rates, as reflected in bond yields, are generally bad news for stocks because they mean higher cost of capital and lower profits for companies, but that analysis is perhaps a little too sophisticated for what’s happened in the last week, especially in European markets. A massive tide of European Central Bank liquidity had lifted all boats throughout the first quarter, so much so that by the end of April, almost half of the Eurozone’s outstanding government bonds were yielding below zero. Comforted by the ECB’s safety net, investors chased whatever returns they could still find with increasing complacency. By mid-April, even a 50-year Austrian bond was only paying 0.75%. “The market was very overbought and offering no incentives whatsoever,” says Marc Ostwald, a strategist with ADM ISI in London. Exhibit A is the German 10-year government bond, or Bund, the nexus around which the European capital markets revolves. Just as government bonds generally determine the cost of capital for the economy at large, so the Bund, the risk-free benchmark among Eurozone sovereigns, determines the cost of capital for the rest of the Eurozone. The Bund yield had dropped to as low as 0.07% as fears about the Eurozone sliding into deflation multiplied, but has rocketed skywards in the last week. By lunchtime in Frankfurt Thursday, it was yielding 0.67% (even that is a heavy rebound from 0.76% earlier in the day). “The retracement in Bunds was the reversal signal for all other markets,” Ostwald says. Fed chairwoman Janet Yellen had pointed to similar phenomena in U.S. markets Wednesday, triggering a pullback in many assets by saying that there were “potential dangers” in the current “quite high” level of stock valuations, and that bond markets were showing “a reach for yield type of behavior.” It’s not that the data from Europe has been that good. Manufacturing orders to German industry were still down in the first quarter, according to figures released Monday and economies from France to Finland are still struggling to eke out growth. But confidence has improved sharply as the euro has cheapened and lower oil prices have left more money in consumers’ pockets. Most importantly, banks are starting to lend to businesses again. Another big factor in the reversal this week has been the price of oil, which is now up nearly 50% from its low of just over $40 a barrel earlier in the year. As energy prices recover, so inflation is bound to tick up, pressuring both bonds and corporate profits. Crude futures for U.S. delivery had weakened overnight but are looking stronger again as New York opens, at just under $61/bbl.