1/12/21: After bottoming out last August at an historical low of 0.5 per cent, the 10-year Treasury yield inched higher, closing the year at a post-pandemic high of 0.91 per cent. The results of last week’s Georgia election, which gave Democrats control of Congress, pushed the benchmark rate above 1 per cent for the first time since March. Financial markets have feasted on a steady diet of continually lower interest rates. What would happen if rates were to reverse course?
The benchmark 10-year Treasury yield is the basis upon which stocks and bonds are priced, including borrowing rates for corporations, municipalities and household mortgages. The correlation between the 10-year Treasury and A-rated corporate bond yields has been nearly perfect over the last 20 years. Historically low interest rates are also the reason why market price-earnings (P/E) ratios are trading at all-time highs. Earnings yield, the reciprocal of the P/E ratio, has traditionally closely tracked the BBB bond yield, even though that relationship changed somewhat when the Federal Reserve embarked on quantitative easing in 2009, its emergency yield curve management program.
Given their cozy correlation, higher 10-year Treasury rates would likely push the stock market’s earnings yield higher, thus compressing equity market P/E ratios. All other things being equal, a 1 per cent rise in 10-year rates would push the S&P earnings yield from 4.3 per cent to 5.3 per cent and compress the market’s P/E ratio of 23x to 19x. Without an offsetting increase in earnings, that would imply an 18 per cent market decline. The good news is the S&P’s earnings yield is currently 2.1 per cent higher than the BBB bond yield, leaving a valuation cushion so the market could likely withstand a 1.5 percentage point rise without substantial valuation deterioration.
Near-term dynamics suggest rates should be higher. Even though we’re coming off the largest annual economic decline since the Great Depression, several forces point to higher growth ahead. The recent Georgia election solidified Democrat control of Congress and increased the likelihood of additional relief. We estimate hundreds of billions of additional fiscal spending will be unleashed to support the economy. Meanwhile, Americans stashed away more than $1 trillion of additional savings last year. Pent-up demand for services, travel and live entertainment, combined with that stockpile of cash, will add up to record spending in H2/21. Market participants agree. Cresset’s copper/gold model is pointing to a 2 per cent 10-year Treasury yield, nearly one percentage point higher than where it stands today. Purchasing manager activity, reflecting both the goods-producing and service sectors in the US, confirms that trend.
Longer term, however, secular forces will likely keep rates low. Historically, the 10-year Treasury yield reflected economic conditions, most notably nominal GDP (real economic growth plus inflation). It was that yield that protected Treasury buyers’ purchasing power with an added benefit of growth. Nominal GDP growth has slowed over the last 40 years, dragging rates down with it.
Aging populations in the developed world further explain slowing growth and lower rates, since retirees tend to save more and spend less than their younger cohorts. Nearly 17 per cent of the US population is over the age of 65 – up from 13 per cent a decade ago. Germany’s senior set accounts for nearly one quarter of its population. Birth rates in the developed world, at 1.6 children per woman, are about half of what they were in the 1960s. As a result, labor force growth rates, a key contributor to potential GDP, are falling as well. While productivity gains can contribute to higher potential growth rates, they haven’t been strong enough to offset labor force growth shortfalls.
Though near-term imbalances, including central bank interference, have contributed to interest rates being too low for economic conditions, longer-term trends suggest rates will remain at historically low levels. That implies that seemingly high equity market valuations may be justified over the longer term.