Interest rates took off last week as investors grew more confident of an economic recovery. One problem: Inventories can be ill-prepared for the increase.
The yield on 10-year Treasury debt fell to 1.1% Friday from 0.91% on Monday. With the Democratic takeover of the Senate, Congress is more likely to approve spending at least a few hundred billion more dollars to support the economy. This means that better growth and slightly higher inflation could emerge. Bond yields reflect these expectations.
“The reason why they [rates] are peak is in anticipation of a relaunch, ”said JJ Kinahan, chief market strategist at TD Ameritrade Barron’s. “Are we heading towards an inflationary scenario?”
A gradual rise in interest rates is usually seen as a sign of optimism, but a sudden spike in yields – or one that the market is not yet valued to reflect price – could become problematic for stocks. Higher interest rates put pressure on stock valuations as they erode the value of future corporate earnings.
And valuations are currently elevated, reflecting the decline in interest rates in historical terms. S&P 500 stocks are trading on average just under 23 times expected earnings for the coming year, well above the long-term average of around 15 times.
“Even US 10-year bond yields now just above 1% could be enough to hit that tipping point where the stock bubble bursts,” wrote Albert Edwards, global strategist at
The Federal Reserve is investing money in the bond market to keep prices high and interest rates low to stimulate the economy, but Edwards, who is known for his consistently bearish views, said even the Fed might not not be able to stop the bleeding.
Even with increasing returns, investors are paying an increasingly higher price for stocks. the
finished Friday up 3.3% from Monday’s closing level.
Valuations, while strained according to some, are arguably not at nosebleed levels. At current prices, the S&P 500 equity risk premium – the earnings reported by the average index share in addition to what investors might get from holding 10-year Treasury debt – is 3.27% . The premium often hovers just above 3%, suggesting that valuations are not out of control.
At the same time, however, it rarely drops below 3%, and when it does, stocks often fall. Edwards says in his report that the data suggests bond yields should rise. If stock returns did not rise accordingly, it would mean a tighter risk premium.
He said yields on 10-year Treasury debt tended to rise and fall in line with movements in the Institute for Supply Management’s purchasing managers index, or PMI, for manufacturing. And that metric recently hit about 60, the highest level since 1995. That should equate to a 1.2 percentage point increase in 10-year yield.
If rates rose so quickly, without the profit gain that a higher PMI and a stronger economy would normally bring, stock valuations would fall.
Look at the rates.
Write to Jacob Sonenshine at [email protected]