04.12.2022: For most of the past decade, equity bulls viewed equity valuations through a bond market lens, arguing that, despite vertiginous price-earnings ratios, stocks are cheap when gauged against miniscule bond yields. Before the financial crisis, the S&P 500’s earnings yield (earnings divided by price) mimicked the 10-year, BBB corporate bond yield. The relationship was predicated on the assumption that the BBB bond yield equated to most companies’ cost of capital. But the financial crisis changed all that. How?
To stabilize and stimulate the economy, the Federal Reserve embarked on a massive bond-buying program. Investors believed that having an enormous price-insensitive buyer snapping up 10-year Treasury notes constrained bond yields below their fair value. The Fed’s balance sheet expanded from about $900 billion to $2.3 trillion in Q4/08, and as of late last year its bond holdings swelled toward $9 trillion. To suggest the Fed didn’t influence Treasury yields would be like asserting that Lycra plays no role in yoga. Over the course of the last decade, the Fed’s Treasury purchases often represented 50-150 per cent of the Treasury’s debt issuance.
The yield differential between the S&P 500’s earnings yield and its corporate bond counterpart reached 4.3 per cent in September 2011 and vacillated around 2 per cent between 2013 and 2021. This year, however, a resoundingly hawkish Fed, alarmed by inflation conditions not seen since the Volcker years, drove bond yields dramatically higher. The 10-year Treasury rate has surged 1.25 percentage points this year, its steepest climb in decades.
How high could rates go? Cresset’s copper/gold model suggests bond yields may have finally reached an equilibrium point, at least for this cycle. We will continue to monitor our copper/gold model. This morning’s 8.5% CPI report shows inflation at its highest level since 1981. Perhaps, as our copper/gold model suggests, inflation has peaked.