By Jan Erik Wärneryd, Hillswick Asset Management

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.

Source: Bloomberg

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%…

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