Treasury Yields Will Become a Headache for Stocks Around 1%
Treasury Yields Will Become a Headache for Stocks Around 1%
(Bloomberg) -- The current melt-up in U.S. stocks may be put to the test by a persistent steepening in the yield curve, an analysis of discount rates, equities and Treasury yields shows.
Correlations between stocks and bonds have come under closer scrutiny in recent weeks with equities climbing to unprecedented highs despite a poor economic outlook. At Tuesday’s record close of 3526, the S&P 500 Index is trading at a discount rate of 3.68% on earnings projected at $130 a share. That suggests a margin of about 300 basis points over the current 10-year Treasury yield, which is broadly consistent with the gap against the index’s earnings yield at the end of last year.
Assuming the Treasuries plus 300 basis-point margin holds, any steepening in the curve that takes the 10-year yield to 1% could send the S&P tumbling to 3250, an 8% drop from the current level, based on the study. A yield increase to 1.25% may mean a 13% slump in stocks.
Higher Treasury yields should boost the additional compensation that investors demand to hold equities instead of bonds, a premium that exists to reflect the fact that stocks don’t promise a return of capital at maturity, unlike bonds. That increase should in turn weigh on stock prices.
Chair Jerome Powell ushered in a tentative steepening of the U.S. yield curve last week when he said the Federal Reserve would seek inflation that “averages” 2% over time, allowing it to run hot following periods below target.
After the unveiling of the Fed’s new framework, the bias for a Treasury bear steepening may persist, albeit more likely in fits and starts for now. Moreover, with much of the curve still very much in market-imposed control, any increase in yields is likely to be a slow grind. The Fed will also probably be wary of a swift steepening for fear that it may imperil any incipient economic recovery.
The ascent in yields has been modest so far, and hasn’t derailed the equity rally. Yet there is no denying that the universe of U.S. stocks is more expensive than it was even during the dotcom bubble. The ratio of the combined market capitalization of the Wilshire 5000 constituents to the nation’s gross domestic product is around 190%, having surpassed the 167% level that prevailed in March 2000.
A caveat to the findings: stocks also have the potential to slump from current levels alongside Treasury yields if it turns out that the recovery -- which the market is counting on -- fails and the economy actually goes into a depression-like scenario.
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NOTE: Ven Ram is a currency and rates strategist for Bloomberg’s Markets Live. The observations are his own and not intended as investment advice.
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