Rising interest rates may be a blessing in disguise for stock investors, who have capped a rally of 15.4 percent in the benchmark S&P 500 this year on concern about higher bond yields.
That’s because rates, and corresponding bond yields, are often a sign the economy is strengthening and corporate profits are accelerating.
Investors, however, are fixated on the Federal Reserve’s $3 trillion — so far — bond-buying program, which has driven yields to record lows, decreasing borrowing costs for companies and consumers.
When Fed Chairman Ben Bernanke signaled two weeks ago that the central bank could taper the stimulus, also known as quantitative easing, bonds tumbled. In all, the 10-year Treasury yield spiked 50 basis points to 2.16 percent in May, and the bond-market meltdown even spilled over to stocks. Equities have seesawed for two weeks, producing higher-than-average volatility.
|Investors are fixated on the Fed’s $3 trillion bond-buying program.|
Investors may be discounting signs the economy is getting back on track almost five years after the Great Recession began. Consumer confidence last month jumped to the highest level in almost six years, profits at companies in the S&P 500 are near record highs, and Fed policymakers have said curtailing quantitative easing could happen as early as this summer if a robust economy pushes down unemployment.
Granted, there has been a very tight correlation in recent years between the Federal Reserve’s multiple forays into quantitative easing and stock-market gains, as shown in the graph above. That’s why investors are so easily spooked at even the slightest hint the Fed may consider tapering its bond-buying program.
Low yields have supported stocks for so long that some investors can’t remember a market without the Fed’s massive money printing. But here’s why investors may be overreacting and have nothing to fear from higher rates — at least not yet.
It’s Not Size That Matters
Interest rates will inevitably rise from record lows; it’s a matter of when, not if. So it’s understandable why investors were rattled by the recent spike in yields. But it’s not the size of the move that matters so much as Treasuries’ absolute yields.
More important is whether yields rise enough to compete with the expected return from stocks. And, although interest rates have indeed jumped, they still have a long way to go, historically, before providing real competition for stocks, as the chart below shows.
In fact, the recent move is barely a blip in the long-term trend and hardly worth fretting about. In fact, 10-year Treasury yields are only about half the level they were just five years ago … in the midst of a global recession.
Indeed, not so long ago, 4 percent to 5 percent was considered a floor under yields, but now it’s a ceiling that appears so far away.
Yields Remain Below the Danger Zone
As for rates’ impact on stocks, historically, 10-year Treasuries would have to yield 6 percent or more before bonds become a real threat to stocks. But why is 6 percent the danger zone for stocks? Because that is the average long-term growth rate of the U.S. economy.
Once the risk-free yield on Treasuries crosses this threshold, the cost of capital available in the real economy begins to get expensive for business and so does the carrying cost to own equities. But rates are far away from that level.
Today, we live in a negative real interest rate environment, where inflation is higher than bond yields. An alternate method of comparing the valuation of stocks versus bonds comes from the Fed itself.
Economist Ed Yardeni picked up on a graph, above, published by the central bank in a 1997 monetary policy report. The graph shows a close relationship between the 10-year Treasury yield and the earnings yield of the S&P 500, which is simply the yield on expected earnings as a percent of stock prices (the inverse of the P/E ratio).
The Fed’s “valuation model” currently shows stocks may be 75 percent undervalued relative to bonds. Said another way, even with bond prices down and the S&P 500 up 15.4 percent this year, bonds are still overvalued compared to stocks.
Don’t Fear the Old Normal
Sure, at some point, the Fed will begin to “normalize” its interest rate policy, but I doubt that moment is close at hand. This may be a concern for investors next year or in 2015, but it seems unlikely to happen at this month’s Federal Open Market Committee meeting, as some investors fear, or at any time this year.
Consider that the last time the Fed began hiking interest rates was in mid-2004, when the federal funds rate was resting at the ridiculously low level of 1 percent. The Fed raised rates 17 times (in quarter-point increments) for the next two years before capping the federal funds rate at what now seems like an equally ridiculously high 5.25 percent.
Through that period of tightening, the S&P 500 posted returns of 17.4 percent, including dividends. That’s historical proof that, far from being a curtain call for stocks, higher interest rates could instead be a welcome development.
That is, so long as yields are rising for the right reasons … signaling an improved outlook for the economy and corporate profits. That would also mean bullish prospects for equities.
Plus, stocks should directly benefit from rising yields and falling bond prices. Investors have pulled $280 billion from equity funds since March 2009, while shoveling $1 trillion into bond funds. Recently, mutual fund flows have begun to reverse, but it’s only the tip of the iceberg.
During May alone, the average long-term government bond fund lost 6.5 percent of its value as yields rose. Meanwhile, the S&P 500 surged another 2.3 percent, though gains were recorded in the first half of the month.
If these trends continue, it won’t be long before the great rotation begins in earnest … as investors stampede out of bonds and back into stocks, giving the equity market an added boost.