Thanks to nearly a decade of quantitative easing by the Federal Reserve, the European Central Bank, the Bank of Japan and dozens of other developed market central banks, interest rates are too low relative to current economic conditions. The Fed, ECB and BoJ alone have injected nearly $15 trillion into the global financial system since 2009: a sum that exceeds the value of all US stocks at the time QE was launched. And they’re still at it. Notwithstanding the Fed’s tapering program, which began 18 month ago, central banks have injected another $200 billion into global financial markets over the last 12 months. As of September, $6.3 trillion of bonds outstanding globally offered negative yields to investors. That’s down from a peak of over $12 trillion in 2016.
The overhang of negative yielding bonds has kept a lid on intermediate US Treasury yields, which have had difficulty piercing 3 per cent. That will change now that rates are rising abroad. We believe “fair” value for the benchmark Treasury is around 4.5 per cent; we arrive at that number from two different methodologies.
The first is based on nominal GDP. Historically, the 10-year Treasury note yield tracked US nominal GDP (real GDP + inflation). Notwithstanding 4.2 per cent growth in Q2, America’s sustainable economic run rate is about 2.5 per cent; add an inflation rate of 2 per cent and we arrive at a 4.5 per cent nominal GDP. The second is based on the S&P 500 earnings yield, or the reciprocal of its price/earnings ratio. Historically, the S&P’s earnings yield tracked the 10-year, triple-B bond yield, representing the funding cost of most index constituents. The earnings yield and the triple-B bond yield tracked nicely until the Fed’s quantitative easing commenced in 2009. By September 2011, the S&P’s earnings yield exceeded its fixed-income counterpart by 4.3 percentage points, supporting the argument that equities were cheap relative to bonds, but also that bond yields were too low. Since then, the S&P 500 returned nearly 200 per cent while the 10-year yield meandered from 1.7 per cent to 3.2 per cent where it is perched today.
As of this morning, the S&P’s earnings yield is 5.6 per cent, one percentage point above the 4.6 per cent 10-year, triple-B bond yield. If the equity market is accurately valued (a big “if”) and credit spreads are fair, then the 10-year Treasury yield should be 4.2 per cent, not 3.2 per cent. If, on the other hand, equities are expensive, due to their “only-child” status among asset classes, then blue chips could lose between 10 and 15 per cent as the 10-year Treasury yield finds its way back to 4.5 per cent.