Will Higher Bond Yields Derail the Stock Market?

There has been a lot of talk lately about how rising interest rates are causing the stock market to retreat from recent highs and how we may risk entering a bear market if the Federal Reserve keeps tightening.

It is almost mind-boggling how quickly things change – I seem to remember just a few months ago the market  was worried about bond yields being too low; the flattening yield curve was seen as a warning of a coming recession. So now that the curve is steepening the worry is that it signals the return of inflation, which in turn will push rates higher and drag down the equity market.

For some perspective on the relationship between bond yields and the equity market, let’s look at some charts showing some recent history. This shows a version of the “FED Model” that compares the yields on stocks and bonds.

The chart above shows the spread between the Earnings Yield (inverted P/E) on the S&P 500 Index and the real yield on the 10 yr Treasury note. I’m using real yields here in order to address one of the most common complaints about the” FED Model”  which is that it compares the nominal yield on bonds to the yield on real assets like stocks.

The period we are looking at here starts 7 years ago in February 2011 and it shows that the yield advantage in stocks has fallen from a high of about 8% in the 2011-2013 period to just below 4% now.

Some market commentators have argued that because we are now at the richest levels in equities versus bonds in many years, we should expect a sell-off as investors rebalance out of stocks into bonds.

For some perspective, let’s see what a longer history of the relative yield relationship shows:

Now, being at just below 4% doesn’t look so bad, does it? In 1999 we bottomed at a real yield spread of NEGATIVE 1.06%…

The real issue is which timeframe is the correct one? Are we in a new era after the 2007-8 financial crisis where the relationship between stocks and bonds has  changed permanently?  Is it an era where (real) interest rates will have to stay much lower than in previous decades because of the fragility of a debt-laden global economy?

Or maybe we are heading back to the relative valuation range that prevailed for decades before 2007-8?

Let’s look at an even longer time frame; in this case going back to 1982. The chart below shows the spread between the S&P 500 Index earnings yield in nominal terms (not real) unlike the previous examples where I used TIPS yields to represent real Treasury yields. TIPS (Treasury Inflation-Protected Securities) were first issued in 1997, so we do not have access to a good ex-ante (forward-looking) measure of 10 yr real Treasury yields before then.

Again, the longer perspective shows that we are at the higher end, meaning more attractive, relative valuation range in equities versus bonds. Equities are not as attractive relative to bonds as they were during the 2011-13 period but they are still yielding much more than 10 yr Treasuries, which incidentally was rarely case from the early 1980’s to about 2002. So, during most of the 80’s and 90’s, Treasury yields were higher than the S&P 500 earnings yield by about 2 to 4%, while now the earnings yield is almost 2% higher than the Treasury yield.

It is difficult to say which perspective we should take here: is the post-crisis experience the one that should dominate our thinking or will we go back to the relative valuations of previous decades?

My own view is that with central banks normalizing monetary policy, interest rates will continue to increase. Some of the rate increase will be because of higher inflation which will mitigate the rise in real interest rates. Ultimately, it is real rates that should impact the valuation of stocks since corporations can raise prices to compensate for inflation.

Real rates are still at extremely low levels, as shown in the chart below featuring the real yield on 10 yr TIPS. In the late 90’s, TIPS yields were around 4%; we are now at 0.78%. As long as real rates stay low, equities are likely to enjoy relatively high P/E ratios since the bond alternative yields so little.

Jan Erik Wärneryd is a Senior Portfolio Manager at Hillswick Asset Management, a participant in the ETF Strategist Channel.