Interest rates took off this week as investors grew more confident in the economic recovery. One problem: Stocks may be ill prepared for the increase.
The yield on 10-year Treasury debt rose to 1.1% by Friday from 0.91% to end Monday. With the Democrats winning control of the Senate, the likelihood has increased that Congress will approve spending at least a few hundred billion more dollars to prop up the economy. That means better growth and slightly higher inflation could emerge. Bond yields reflect those expectations.
“The reason they [rates] are spiking is in anticipation of stimulus,” JJ Kinahan, chief market strategist at TD Ameritrade told Barron’s. “Are we headed to an inflationary scenario?”
A gradual move higher in interest rates is generally seen as a sign of optimism, but a sudden spike in yields—or one the market isn’t yet priced to reflect—could become problematic for stocks. Higher interest rates pressure stock valuations because they erode the value of future corporate profits.
And valuations are high at the moment, a reflection of how low interest rates have fallen in historical terms. Stocks in the S&P 500 trade at an average of a bit less than 23 times the earnings expected for the coming year, far above the long-term average of about 15 times.
“Even U.S. 10-year bond yields now just above 1% could be enough to hit that tipping point where the equity market bubble bursts,” wrote Albert Edwards, global strategist at
The Federal Reserve is plowing money into the bond market to keep prices high and interest rates low to stimulate the economy, but Edwards, who is known for his perennially bearish views, said even the Fed may not be able to stop the bleeding.
Even with the increase in yields, investors have been paying an increasingly higher price for stocks. The
ended Friday up 3.3% from Monday’s closing level.
Valuations, while stretched according to some, are arguably not at nosebleed levels. At current prices, the S&P 500’s equity-risk premium—the earnings yield the average stock in the index brings in over and above what investors could get from holding safe 10-year Treasury debt—is at 3.27%. The premium often hovers just above 3%, suggesting valuations aren’t out of control.
At the same time, though, it rarely falls below 3%, and when it does, stocks often drop. Edwards says in his report that data suggest bond yields are set to surge. If earnings yields on stocks didn’t rise correspondingly, that would mean a narrower risk premium.
He said that yields on 10-year Treasury debt tend to rise and fall along with moves in the Institute for Supply Management Purchasing Manager Index, or PMI, for manufacturing. And that measure recently hit roughly 60, the highest level since 1995. That should correlate to a 1.2 percentage-point increase in the 10-year yield.
If rates quickly soared that much, without the gain in earnings that a higher PMI and a stronger economy would ordinarily bring, stock valuations would tumble.
Write to Jacob Sonenshine at email@example.com