- How does the spike in 10 year yields compare to 1994? What was the impact on the S&P-500 ?
- Is a ~1% move in long-term bond yields market risk or market noise?
- Should you be worried about inflation today or higher valuations in the face of rising yields?
In 1994 the ongoing decline in US 10 year bond yields was interrupted by a significant spike over an 11 month period. Yields rose from a low of 5.19% November 1993 to a peak of 8.01% at the end of October 1994. The absolute rise in yields was a material +2.82%. But to put this in perspective, the yield had declined from a peak of ~10% in 1988 to that low in 1993.
The P/E ratio for the S&P-500 was 21-22x in 1993 & 1994, with valuations having increased from low-teens following the early 1990's recession. The recession caused inflation to reduce from an annualized rate of 6.3% in 1990 to 2.5% in 1994. Rising yields, in addition to other factors, caused the S&P-500 to decline -8% in 1994, from peak to trough.
P/E multiples often look expensive coming out of a shock to earnings or a recession. So heed caution to what valuation measure you look at. Similarly, bond yields often rise following a recession as inflationary expectations are typically savaged during the downturn in addition to declining cash rates.
Today, the 10 year yield has increased from 0.54% to 1.52% yesterday, an absolute gain of +0.98% to date. Although clearly yields could continue their march higher.
The US 10 year breakeven inflation rate is currently 2.15%. Inflation tends to take time to rise when the output gap is wide as the economy still has ample slack in employment and wages. Some investors will point to the most volatile components of inflation, namely commodity prices, but history indicates that some inflation may not be all bad news. With reference to the below chart, historically inflation ranging from -1% to +4% has been associated with relatively high P/E multiples.
Is this market risk or market noise? It all depends on the assets you own. Rising bond yields are a positive development as bond markets are signalling improving expectations for growth and inflation. Stock markets, theoretically, are (imperfectly) valued on their expected growth and dividends relative to a risk-free rate, such as the 10-year bond yield. If bond yields rise quickly this may pose a risk to stocks that you may wish to mitigate. Nonetheless, market risks are low and remain constructive.
From here asset prices may take time to consolidate their 2020/21 gains. But, if you own highly speculative investments, especially companies with little earnings trading at large valuations, then rising bond yields may become more problematic for your portfolio.
Rising bond yields and inflationary expectations will impact various long-dated, or long duration, assets negatively as you have seen unfold this week. How high do you think bond yields will rise from their 0.54% low in 2020? If you look to the bond panic in 1994, you'd need a lot larger absolute gain in yields to impact broader stock markets materially. If a healthy broader pullback unwinds overbought conditions the party may continue, just perhaps not so much for the speculators holding overpriced assets. But keep things in perspective as absolute yields are yet to increase more than 1% from their lows.
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