Contrary to conventional wisdom, U.S. Treasury yields may stay low – and lower – for long without triggering any strong buying interest for stocks: higher dividend yields would be here to stay.
In a ZIRP environment, the relationship between the slope of the yield curve and growth expectation does change. In normal regimes, a bull flattening is a sign of stronger growth ahead. If the short end is pegged, only a bear steepening can point to better growth ahead.
The chart below shows that the UST 2/10-year slope disconnected somewhat from the SP 500 (SPY) since the inception of the crisis.
Up to the point when the Fed Funds rate reached zero, the relationship held. Since mid-2008, curves move in opposite direction. The recent sell-off in equity markets came along with a significant flattening.
Yet, could higher rate come from an arbitrage in favor of equities?
Is this Japan 1990? Or US 1950?
Equity bull investors would stress the fact that earning yields are well above UST yields, a sign of unusual risk aversion (Fed Model) and a strong buying opportunity. This approach is based on the assumption that both yields should mean revert.
As we have stressed before, the fact that there is plenty of liquidity (14% of global GDP vs. an average ratio of 5% in the previous decades) suggest that the “yield competition/arbitrage” between asset classes is not as fierce as before.
In some ways, it may not be ill-advised to compare the US to Japan in the early 1990s. Some lessons could be taken in the handling of the banking system crisis, non-performing loans and the conduct of fiscal policies (too early VAT hike in 1997 for instance).
A look at the past - the 1950s - may also be helpful: before Markowitz and the 1960s, the link between UST 10 year yield and the SP 500 dividend yield was non existent. In 1955 for instance, UST 10-year yield stood at 2.8% whereas the Earning yield reached 8%.
Interestingly, this pre-960 period witnessed a sharp deterioration of the debt-to-GDP ratio. This post war deterioration in public finances came along with some domestic financial repression (regulation Q…) that forced domestic agents to get savings yielding negative rates.
- The medium run public debt trajectory has not been fixed in spite of the debt ceiling agreement.
- The Fed is trying to trigger a demand switch in the holding of US Treasury from foreign central banks to domestic commercial banks. It also targets negative real interest rates as a means to accelerate domestic deleverage.
If investors continue to loom on the bad side of the US economy:
- Some further flattening is most likely
- Lower bond yields will not trigger higher stock index prices if “the competition for yields” stalls for a while.