This article was amended on 01/18/22 to reflect a minor clarification related to the spread expectations.
Real yields are racing higher, with the 5-yr TIP rate now at -1.22% the morning of January 18. It was just on January 4. The 5-yr "real" yield was -1.6%. This move higher in real yields puts pressure on equity market valuations. The higher this rate climbs, the more the earnings multiple will contract. The biggest problem for the equity markets is that the "real" yield on the 5-yr TIP may be about to go much, much higher.
A technical chart shows that the 5-year TIP rate may make a significant breakout, sending that real yield soaring from -1.22% to around -50 bps. That would be an increase of more than 70 bps, creating carnage in the already overvalued equity market.
The more hawkish the Fed gets, the more real yields need to move higher. Some estimate the Fed owns around 25% of the TIP market, which is massive. Now that the Fed is winding down QE, the buying pressure for TIPS in the market will subside, likely resulting in rising yields. Should the Fed begin to unwind the balance sheet, well, there's only likely to be more upward pressure on TIP yields.
A move of 70 bps on the TIP yield would put considerable pressure on the S&P 500 earnings yield of 4.78%, sending the S&P 500 earnings yield up to 5.5%. That is more in line with previous bottoms, dating back to 2018 and 2020. That would push the S&P 500 PE ratio from its current level of around 21 to about 18.2, a decline of 13.3% or roughly 3970.
It creates a real problem, and maybe worse, for the Nasdaq composite's earnings yield. It would rise from its current 3.38% to around 4.1%, pushing its PE ratio to 24.4 from 29.5, a drop of 17.6%.
It looks pretty likely that rising real yields will negatively drag on equity markets. The correlation between the actual one-year change in the 5-yr TIP rate and the actual one-year change in S&P 500 earnings yield over the past 5-years is very high, at 0.71. It's also effortless to see the relationship in the chart below, with both moving in near lock-step. The chart shows that more recently, the earnings yield of the S&P 500 has been moving sideways while the real yield has risen sharply. One could say the S&P 500 earnings yield has only started to move higher.
Currently, the spread, or the difference, between the S&P 500 earnings yield and the 5-yr TIP rate is 5.97%. Which over the past eight years is pretty wide. It would imply that the S&P 500 is reasonably cheap vs. the 5-yr TIP rate. But the problem now for the S&P 500 to maintain that current spread, the index's earnings yield will need to rise basis point for basis point with the 5-yr TIP. If the TIP rate explodes higher, which given the macro backdrop, seems more likely than not, it will inflict a lot of pain across equity prices, especially those that carry very high multiples.
What seems likely to happen is that the spread will widen back to around 6.5%, which is where the index was trading during this whole time. It would imply an S&P 500 earnings yield of about 6%, equal to an S&P 500 PE ratio of perhaps 16.7 or 20.9% lower than its current level, or 3,630.
Yep, stocks rose quickly on the low real yields narrative. Now, they are likely to fall just as fast as the game is over.
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