In anticipation of the Federal Reserve FOMC meeting this week, there is a lot of handwringing over interest rates and the relationship between stocks and bonds. Although expectations for this FOMC meeting are for a very tame outcome – the Fed will continue to taper its quantitative easing program by $10 billion and probably mention the US economy being on a slightly better trajectory – the larger picture of a potential re-pricing of the interest rates curve is at play. Accordingly, a quick and very simple thought exercise on how the US 10yr Treasury Bond (the “US 10yr”) relates to US stock performance may be valuable.
Is there a correlation between the US 10yr and the S&P 500? The answer is unequivocally yes. There are correlations aplenty and the bond market is frequently a driver of the stock market or vice versa. Many of the statistics recently bandied about are shorter term correlations and statistical relations rather than longer term views. The longer term trends are what matter more.
Some rudimentary ideas about the relationship between stocks, interest rates and the yield curve frequently include:
- When interest rates rise, it is generally bad for stocks because it makes the cost of capital higher;
- When interest rates rise for the “right” reasons, it means that the economy is in high gear and entering a higher growth cycle which is good for stocks; and,
- When interest rates rise it means that the Federal Reserve is worried about inflation. Therefore, whether rising interest rates are good/bad for stocks depends upon the level of inflation and whether the Fed is “ahead” of inflation or playing catch up.
The idea of a strong correlation between US stocks and the US 10yr is pretty obvious. One need only to look at the fact that as the yield on the 10yr, which is in large part driven by monetary policy and interest rates, has trended down, stocks have trended up.
The bigger question is over valuations. In the chart below, the price-to-earnings ratio of the S&P 500 is compared to the yield on the US 10yr. Obviously, the trend lines point to the fact that stocks have become more expensive, in a valuation sense, as US yields as measured by the US 10yr have decreased.
Why do stock valuations increase if yields and presumably interest rates are going down? Because investors are willing to pay more (multiple expansion) for earnings when they are not denigrated by inflationary pressures and the cost of those corporate earnings is cheap on relative terms. Again, this is very straightforward analysis, but often times it helps to remember that which is self-evident.
An elementary analysis or previous times of rising US 10yr yields shows:
- From 1978 through 1981 the S&P 500% rose 39%
- From 1984 through 1985, the S&P 500 rose 8%
- From 1987 through 1988, the S&P 500 rose 14.7%
- From 1993 through 1994, the S&P 500 gained 5.5%
Ultimately, each time series of rising interest rates occurs in a separate economic cycle with independent facts and circumstances. To create analogues out of history is to create a fiction. Yes, this time will be different, but also the same.
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