T-Bills vs. Fed Funds: A Recessionary Tale

Includes: IEF, SPY
by: Michael B. Krause

A tasty tidbit. Earnings yield of the S&P is historically in mid-range, but relative to fixed income assets, its quite cheap. Currently, peak 2007 earnings (which are likely to fall short in 2008) mean the S&P end of year '07 at closing price of 1468 are priced at a 22% discount (78%) to the ten year bond yield of the same period. Bottom of the range occurred in 1974 with S&P earnings yield trading at 45% discount (or 55%) to the 10 year note.

The ten year note price taken in 2007 is 4.63%, which must be a weighted average (this is from Federal Reserve Data).

Interestingly enough, the Tuesday intraday bottom of 1250 (assuming we get a 15% drop in earnings to total $74 as reflected here) value for 2008 on the S&P against a record low 10 year yield of 3.3%, also achieved this week, put the S&P at a 45 year low price to nearly match the 1974 number, of 45% discount on price for S&P versus the 10 year. If S&P earnings don't fall 15% this year, and drop only 2%, Tuesday traded a record low valuation related to 10 year notes at 49%!

T-Bill Versus Fed Funds

This is yet another interesting relationship.

Fed funds rates tend to lag 90 day T-Bill rates in direction, by the appearance of these charts. This relationship is interesting because the markets in flight to safety often guides the fed via demand for 90 day T-Bills. Notice how 1974 is a trough in both the spread ratio: (T-Bill - Fed Funds)/Fed Funds as well as S&P valuation. This coincided with a deep recession coincident with oil shocks.

The ratio is a more normalized picture, adjusting for periods where yields were much larger and more volatile (12-20% in the early 80s):

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