The 10-year Treasury note (UST) is the big dog in markets. Jim Cramer says it is the tail wagging the dog. And, traders agree. Since Ben Bernanke's press conference took the wind out of the equity market's sails last week, traders have been looking to the 10-year for an indication of what to do. In Monday's trading, yields on the 10-year opened at session highs, then fell to lows before rising at the end of the day. The equity market followed the same pattern, only inverse - starting at session lows, followed by a rally and then a late-day sell-off.
With the Federal Reserve getting out of the bond-buying business, retail investors have decided bonds aren't for them - joined by hedge funds and anyone else holding bonds for value. Given the uncertain global environment, this stampede for the exits runs counter-intuitive to the "risk-on" mantra that so many have been espousing. They would suggest that the recent Chinese equity sell-off and impending credit problems would lead to a bid in Treasuries - however, it did not happen that way. Nothing has been able to stop yields from moving higher over the past week - a trend that is likely to continue.
Long History of Declining Yields
Looking at the monthly chart below, the 10-year note has been in a strong downward channel since 1987 from a yield above 10 percent to the low of 1.4 percent a year ago. Despite multiple tests through the Asian financial crisis, the tech bubble, and even the stock market's run-up ahead of the global financial crisis in 2008, this trend channel has held strong.
The horizontal orange line indicates a double top from October 2011 and March 2012 that was violated with the most recent move higher. I expect that line to offer good support now in the coming weeks on any pull-back in yields.
The Federal Reserve's tapering - or at least end of aggressive buying - should lead yields on the 10-year Note beyond the 3 percent target that many are suggesting, to ultimately 3.5 percent, where the 25-year downward channel will be tested.
Implication for Equities
The last time the yield on the 10-year was at 3.5 percent was in April 2011 - at the same time that the S&P 500 (SPY) was hovering at 1,350 with a forward P/E ratio of 14. Given today's earnings expectations that rebalancing could lead to 1,500 on the S&P - around another 5 percent decline from current values. At that point, I believe cheaper valuations would encourage buyers to enter the market from the sidelines.
As yields on the 10-year move higher, it is also argued that dividend plays will become less appealing. With no risk, investors can earn 3.5 percent - versus 2.5 percent as a current average dividend yield of a dividend-paying stock in the S&P 500. Two months ago, 60 percent of the S&P 500 had a higher dividend than the 10-year Treasury. Now, just 36 percent do.
The worst-performing sector of the S&P 500 lately has been high-yielding utilities, suggesting that yields in and of themselves are no longer a reason to be in a stock. Value will once again be at the forefront, and just in time for earnings season. This earnings season will eventually determine where equities are headed as a group - though, regardless, I suspect the indexes move to lower valuations of 13-14 times forward earnings.
Bullish on the U.S. Economy Isn't Bearish on Equities, Long-Term
The bottom line that markets are ignoring at the moment is that Chairman Bernanke was not issuing a doomsday warning for the U.S. economy. He noted that the U.S. economy may be performing at a pace that would encourage the Fed to be less aggressive - a fact that should be helpful for companies' revenue and earnings growth moving forward.
Additionally, the chairman explicitly stated that any hikes in interest rates were a couple years away. In a pre-2008 world, that would be an extremely accommodative stance for the central bank to take. At this point, we've just had the juice for too long.
Markets are currently in the middle of a re-pricing - letting equity and bond markets find their own two feet with just a bit less support from the Federal Reserve. The sharp moves of the past week are just evidence that no one wants to be left holding the bag when the music stops. When that happens, the economy will be on much better footing - as will earnings prospects.