The yield on the ten year treasury is drifting up to 5% which is prompting discussion as to whether this spells trouble for equities and if 5% is not a problem what yield would be.The bigger idea is that there is some yield that would entice an investor to sell stocks in favor of bonds. For example if 15% for long dated treasuries were ever available again a lot of people would dump their stocks and take that yield.
I heard part of a discussion on Kudlow that the Fed model called for stocks to be at equilibrium to bonds at a 5.13% ten year yield (I heard this in the car so if it was some other model please leave a comment). The show said that currently stocks are undervalued using this model. The big watch out with relying on this too much is that stocks can remain undervalued or over valued for years. In my opinion this offers no predictive value whatsoever.
While I have been expecting a correction in stocks for months I don't think 5% or even 5.1% will be the tipping point for a lasting decline. The S&P 500 is up better than 8% YTD including the dividend. Given the tendency to project past return forward I don't think allure of an extra 20 basis points is really much of a hook. But of course I could be wrong.
Perhaps this could cause a rotation within the bond market to lengthen maturity as a more likely first step. I would think that yields will normalize and that the middle of the curve will work its way back into the sixes but I am not sure how long this should take. Getting 6.25%, for example, would be much more competitive for me versus stocks. At some point above 6% I could see moving 5% from equities to bonds, above 7% a little more and 8% or above even more.
Of course the details would depend on whats happening all over but the thought process is very simple, at some point (different for everyone) bonds become cheap and the weight should be increased. If yields never go up then I will stick with short maturities and the current weightings.
It makes sense for you to think about this now before it happens so you are prepared to make changes if need be.
9 comments:
I wrote about this last night also -- wish I had written about it sooner, because it seems like everyone is jumping on this theme now. (That would ordinarily worry me, but I suspect we are early in this move...)
I don't think 5.13% on the 10-year Treasury is the equilibrium value for US stocks versus bonds. I have an article coming soon that will suggest that the equilibrium level is roughly 2% over the earnings yield on the S&P 500.
So, I am not strategically moving away from stocks yet (except for my rebalancing); in the short run, the higher interest rates will indicate faster global growth, which will be positive for stocks. The probability of difficulty for stocks does rise as interest rates rise; over 6.5%, the tune should change.
thank you David. 6.5% would leave a mark, I agree.
Part of me wishes we have an awful year where yields go to 8%, that would be a nice one to marry for a decade I think but who knows what the other fallout would be.
Rising bond yields affect the stock market in so many different ways besides competition for investment dollars. There is (in no particular order) corporations' cost of borrowing, option pricing, interest cost for borrowing on margin, home mortgage rates (which affect home values and home sales rates and every industry related to that), credit card interest rates, etc. Can those things move independently? Sometimes, for a little while maybe, but don't make any bets on that...
What the investor should be trying to figure out here isn't whether a bond selloff is bad for the market (of course it is), but rather whether the recent selloff is part of a long term trend is just a capitulation to the wrongheaded idea that the Fed might be thinking of cutting rates any time soon.
I'd be more concerned about corporate balance sheets and LBOs. Higher interest rates reduce borrowing at the margin, every step of the way.
I don't think interest rates are fully to blame, but utilities are getting hit.
I read elsewhere that "Stocks fell for a third straight session Thursday after rising bond yields stoked concerns that an interest rate cut later in the year is less likely"
Why would rising bond prices make people think interest rates are not going down?
the market is now moving out further in time when the Fed will start to lower. More people now seem to be allowing for the possiility of a hike. Either way short term rates are less likely to go down soon.
If this is because growth is accelerating the rest of the curve should move higher--this is just how it works--as the curve normalizes.
Matthew, it's all connected:
http://www.bloomberg.com/apps/news?pid=20602007&sid=acwW09PCttXQ&refer=rates
st_frenchman, "yields" and interest rates mean the same thing in this context.
Looks like some folks have gotten is bass ackwards. Rising bond yields mean that an interest rate rise is LESS likely, not more. In effect, rising bond prices are doing the job (of increasing rates) for the Fed by dampening down the economy (and hence inflation).
Josh Stern is absolutely right. Rising bond yield will directly impact financing cost for most corporations. As a result, employers will reform their WACC by either delaying or ceasing their projects altogether. This means the unemployment rate will rise above its natural level, and which will lead to a diminishing aggregate demand and an eventual sluggish economy.
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