Current San Francisco Fed President John Williams, who will soon transition to the much more powerful New York Fed, sent a jolt through the bond market. In an interview in Madrid, he struck a hawkish tone, suggesting that the Fed may need to hike more aggressively due to tight levels of slack in the economy. This has sent the 10-year Treasury yield hurdling toward 3% again. Today we won't talk about Williams' argument specifically, since it isn't really new. He's been saying the same basic message for months. Rather, let's explore what a 3% 10-year means to markets and to the economy, what it would mean if it kept going higher.
Are rising long-term rates a problem for the economy? Or for stocks?
The way the media has been covering rates lately has probably given a lot of people the wrong impression about the relationship between interest rates and stocks, and I suspect it will lead to some trading mistakes. Yes, interest rates can certainly have an influence on stock valuations. At its core, a stock's price is the discounted value of future cash flows. If you have to discount those cash flows by a higher interest rate, then all else being equal, the stock is worth less. This was the same logic by which many argued that relatively high P/E ratios in the 2012-2015 period were justified: low interest rates can make a historically high P/E reasonable (or even cheap).
However, this is a simplistic approach to thinking about rates and stocks. In a discounted cash flow valuation, a stock's price is a function of its earnings, the growth rate of earnings, and the discount rate. Just to illustrate, let's use a very basic dividend perpetuity model:
Price = Dividend / (Discount Rate - Growth Rate)
If you just look at the formula, it is pretty obvious that if interest rates rise at the same pace that earnings growth rises, then the stock price doesn't change. That term in the denominator would wind up being exactly the same. In the real world, both earnings and rates tend to rise when the economy is strong, so usually when the 10-year Treasury is rising, that effect is at least partially offset by faster growth. It is also historically true that earnings are much more volatile than interest rates. In the last 5 years, S&P 500 EPS growth rates have been as high as 9.8% and as low as -2.3%. This implies that as a general rule, the growth rate factor tends to be more important than general interest rates. Lastly, the actual discount rate used in valuation models has to assume some kind of risk premium over Treasury rates. It tends to be the case that the risk premium falls during good economic times.
Put all this together and hopefully it is obvious that rising Treasury rates aren't a problem for stock prices as long as the economy is growing. Earnings growth and the risk premium factor tend to overwhelm the rise in base Treasury rates. This is why in 8 out of the last 10 quarters where the 10-year Treasury yield rose, the S&P 500 was up. Indeed, the last time the 10-year rose above 3%, during the 4th quarter of 2013, the S&P 500 rose 167 points. Clearly 3% is not, in and of itself, some kind of death knell for stocks.
So why is everyone freaking out about higher rates now?
All that being said, if rates are rising while earnings are not growing, that's going to be a problem. That's where the flattening yield curve comes into play. As the yield curve flattens, it means the Fed is closer to the end of its hiking cycle. That is because the market needs to price in the near-term period where the Fed is still hiking, but an intermediate term period where the Fed stays steady or even starts cutting. In such a world, short-term rates rise at about the same pace as the Fed's target, since those bonds are mostly influenced by that near-term period. But long-term rates have to price in the period of flat to falling fed funds, and thus don't rise by as much.
This is exactly what's happening now. In the last 6-months, the 2-year Treasury has risen by 91bps, the 10-year by 57bps and the 30-year by just 22bps.
Of course, if the market is pricing that the Fed stops hiking, it is also implying that economic growth stalls. If GDP growth stalls, earnings are also likely to stall. Specifically, a flatter curve is a sign that money is getting tight. Stocks are fine with rates rising because economic times are good. Tight money is a problem.
Will the curve invert?
Let me be crystal clear about this: if the Fed keeps hiking the curve will invert. Yes, I know that John Williams himself claimed that the curve wouldn't invert, because he said the Fed would keep tightening policy at just the right pace to avoid such an outcome. He made the rather bizarre analogy of landing a 747 at just the right speed and trajectory that the passengers don't even know that its time to turn their phones back on. I've been on a lot of 747 flights myself and I've never had a landing that smooth.
This has led some to speculate that Williams wants to see the 10-year rise enough to avoid an inverted curve, and hence his Madrid comments were intended to jawbone the 10-year higher. I'm sorry, but that's a dumb take. The inversion isn't the cause of a recession, it is a symptom that money is too tight. If anything, talking long-term rates higher only serves to make money even tighter. But more importantly, you can't avoid an inverted curve through gimmicks. If you want to keep the inversion from happening, you have to stop hiking before money gets too tight. Anyway, that obviously isn't Williams' goal. He clearly states that he isn't worried about how flat the curve has become, and says that he thinks the roll off of the QE portfolio will help alleviate pressure on the long-end.
As an aside, I don't take Williams at face value when he says he doesn't think the curve will invert. I sure hope he isn't so overconfident as to think this Fed will orchestrate a perfect landing, to use his own metaphor, when no prior Fed regime has ever pulled off such a thing. More likely he is plenty worried about it, but a) can't say that publicly, and b) trusts his models that are telling him the Fed needs to keep hiking.
This sounds very bearish for risk assets
Nothing I've said here is good for anyone. I'm loathe to make some kind of huge call on stocks here. Historically, inversions haven't been ironclad signs of bad stock performance. In fact, I looked back at the last three cycles when the 2-10 year slope fell to 50bps (where it is now), and stocks were higher 3, 6, and 12 months later in all cases. This is mainly because the link between an inversion and a recession isn't absolute. There have been inversions (or near misses) that never turned into a recession, such as 1994. There have also been some where the recession didn't happen until 2+ years after the inversion, such as 1989 or 2005.
What I will say is that we are in the late innings of this expansion. Earnings comps are going to only get tougher. The market is only going to get more skittish. I'm very cautious here.
What to watch
The best near-term indicator is going to be corporate earnings and job gains. If companies start to see sideways end demand for their products, that would be a big red flag. The most bullish data point out there right now is business confidence. If that wanes, I'm going to get real worried. On job gains, I'd say that if job gains start slowing to below +150,000 or so, it probably suggests we've hit a stall speed. That would also have me real worried.
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