Serious Money: Serious Money has often reflected on the significance of bonds: those humble and often rather dull investments that are, paradoxically perhaps, infinitely more important than any other asset class. What happens to bond yields has a disproportionate influence on just about everything.

The last time I discussed bonds, I remarked that the rise in US yields to 5 per cent didn't seem to have affected equities that much. I concluded that stock markets must have been unusually rational in that they had never been tempted to think that the ultra-low yields of the last few years were likely to be sustained. That conclusion was driven by the idea that if equities had been seduced by 4 per cent bond yields, the subsequent rise to 5 per cent could only spell trouble; because the markets had, up until that point at least, reacted calmly, things should, I reckoned, stay that way. Impeccable analysis for sure, but a hopelessly wrong conclusion: stocks just took a while to notice that bond yields were rising and the trouble duly arrived.

Bond yields are important for all sorts of reasons. Government bonds are the nearest we have to a "risk-free" asset, which is a fancy way of saying that because we are almost certain to get our money back, they are the least volatile investment that we can make. They are even safer than bank deposits (for most governments at least).

Being risk-free, they perform a benchmarking role for any other kind of investment, equities in particular. Stocks are risky, so they have to offer a return sufficient to attract investors out of bonds. This premium, or excess return, is the reward that equity investors can expect for taking the risk of losing their money. By arithmetic, if the yield on the risk-free asset goes up, so must the yield on risky assets.

And the only way a yield on an equity (or a bond) can go up, in the short term at least, is if its price falls. So, when bond prices go down (that is, yields go up) so do equity prices. In theory at least.

So far, this is a simple story told in the introductory texts of any basic finance course. The real world is a bit trickier than this because of a couple of factors. First, there is the significance of inflation: it gets a bit esoteric, but a comparison of traditional bonds with equities is actually misconceived because inflation affects the two asset classes via very different channels. And inflation can also affect the premium that investors demand for preferring equities over bonds. And that premium itself can vary over time in quite unpredictable ways. All very confusing and difficult, which is why you don't often see discussion of these issues in any financial market commentary.

But, as at least one leading professor once remarked, the equity risk premium is the most important variable in finance. It may be a tad esoteric, but it is ignored at the investor's peril.

Back to the real world. The equity market correction of the past few weeks can be rationalised, mostly, by the delayed reaction to the earlier rise in bond yields. But the risk premium also rose: for whatever reason, lots of investors simply decided to scale back on their bets. In particular, those punters who had laid bets with borrowed money decided that the time had come to take some money off the table. This is what the commentators mean when they say that we witnessed a lot of "deleveraging".

Normally bullish Serious Money would point out here that the right time to buy stocks is after a rise in the risk premium. The consequence of that rise is that we will be paid more than previously for taking risk. In other words, stocks offer better value. The one niggle I have at the moment is that those bond yields, particularly in the US, have continued to rise.

When I last mistakenly regarded a rise in yields as nothing to worry about, they had drifted up to 5 per cent. Then we had, roughly, a 10-20 per cent correction in stocks, depending on whether we look at developed or emerging market stocks. Right now, yields have again gone up to approach 5 ¼ per cent.

Of course, the market is obsessing over the likely peak in US short-term rates and the debate over whether the new Fed chairman is up to the task of engineering yet another soft landing for the US economy. At this point, we could digress into a detailed analysis of the bond market and its symbiotic relationship with central banks: anyone interested in this should read Caroline Baum's commentaries on Bloomberg.com. Suffice it to say that definitive conclusions are hard to draw.

Three years ago, bonds were fretting about deflation. Today the concern is a return of inflation. Economists: don't you just love them? The conclusion I draw from all of this is that the US equity market is going to struggle until the economists call time on the inflation scare. None of this should, in theory, affect any other stock market, but, this being the real world, we know that it will. But during this period of inflation uncertainty, it will almost certainly be better to favour European over US stocks. Market timers out there should think about buying US equities the day before the market calls the top in US inflation.

Keep an eye on the bond market: the more yields keep ticking up the more pressure, at least in the short term, will stocks be under.

And there is another asset class, just as bond-yield sensitive, that has not yet reacted at all to the rise in those yields: it's called property.

Chris Johns is an investment strategist with Collins Stewart. All opinions are personal.