Real Yields And Stocks

by: Calafia Beach Pundit

This is a follow-up to my post last week, "The importance of real yields," in which I compared real yields on TIPS to nominal yields on Treasuries, real GDP growth rates, and gold. I noted that real yields tells us several interesting thing about the market's outlook: the market does not expect any meaningful change in the rate of inflation; the demand for safe assets is beginning to decline; and real GDP growth rates are expected to be low for the foreseeable future.

The chart above compares the earnings yield on equities (i.e., the inverse of the PE ratio) with the price of 5-yr TIPS (using the inverse of their real yield as a proxy for price). It shows that when equity valuations are high (i.e., when the earnings yield on equities is low), the demand for safe assets is weak, and vice versa, and that makes perfect sense. In the late 1990s, equity markets were booming, the economy was growing at a 4-5% rate, and real yields were usually high. During those go-go years, in other words, the demand for stocks was strong and the demand for TIPS was weak. By the early 2010s, things had reversed: the earnings yield on stocks had soared (corporate profits were very strong but the market was very doubtful that those earnings would hold up), and the demand for TIPS had soared because everyone feared that the economy would remain weak or suffer another recession.

Over the past year, however, we have seen a divergence between these variables. Earnings yields have declined (i.e., multiples are rising), as the market becomes more confident in the outlook for earnings, but real yields have been relatively flat and are still quite low. In other words, the demand for equities is strengthening, but the demand for TIPS is not declining.

I think this is a good illustration of the tensions that are building between the stock and bond markets. Interest rates should be higher, given the rising level of confidence in the stock market. This is a theme that I explored in another post last week, in which I argued that even if real GDP growth is only 2-3%, the Fed should react sooner rather than later to the signs of rising confidence and start raising short-term interest rates.

It seems to me that the stock market is out in front of the Fed and the bond market these days. It doesn't make sense that equity valuations are rising and net worth is at new all-time highs, but short-term rates are zero and 5-yr TIPS real yields are negative. The Fed needs to gain the same confidence as the stock market, and begin raising short-term interest rates. This would likely help give the bond market the confidence to shun Treasuries, thus restoring the balance between earnings yields and real yields.