Tuesday, December 19, 2017

The bond market begins to figure things out

For the past year the stock market has had a blast pricing in tax reform. The S&P 500 is now up some 25% or so since the day before the November '16 election, and that gain is only slightly more than the degree to which a cut in the corporate tax rate, from 35% to 21%, causes a one-time rise in after-tax corporate profits. (Here's the equation: (1-.21)/(1-.35) = 21.5%.) The bond market, however, hasn't taken much notice: 10-yr Treasury yields today are 2.45%, only modestly higher than the 2.33% they have averaged over the past year. On the other hand, 5-yr real yields on TIPS (a key, must-watch indicator as I've argued), today have climbed to 0.37%, which is meaningfully higher than the 0.05% they have averaged over the past year. The rise in bond yields is still modest, but the rise in real yields is better still, since it's the best indicator that the bond market is beginning to price in a stronger economy. And we're still in the early innings. Bond investors, hold on to your hats.

I first raised this issue—how the stock market was excited about tax reform, but the bond market was ignoring the likely consequences—in a post two weeks ago (Tax reform is priced in, but not a stronger economy). It now looks like the bond market is in the early stages of figuring out that a big cut in corporate tax rates is indeed likely to result in an investment boom and a stronger economy in the years to come. The ranks of the Trump despisers have been thinning ever since the summer of 2016, as more and more become convinced he is going to adopt more business- and growth-friendly policies, and the bond market is now beginning to join the party. Yields have just begun what could eventually prove to be a significant move higher, and early signs of that can be found in the slope of the yield curve, which has steepened in recent days.

 Chart #1

Chart #1 shows the slow and gradual uptrend of 5-yr real yields on TIPS. In the past 18 months they have risen by 85 bps, and 70+ bps of that rise has occurred since just before the November '16 election.

Chart #2

To be sure, one of the driving forces behind higher real yields is the Fed. Chart #2 shows how the Fed has raised real short-term rates by about 140 bps (from -1.4% just before the '16 elections to about zero now), by increasing its nominal overnight target rate by 1% during a period in which core inflation has fallen from 1.9% to 1.5%. The same chart also shows how the real yield curve has flattened during that same period, as 5-yr real yields (red line) rose by less than overnight real yields. That's again symptomatic of the bond market's reluctance to believe in a stronger economy. (The Fed has shared this belief, and still holds to it, but that is likely to change going forward.)

Chart #3

Chart #3 shows how real yields on 5-yr TIPS have a strong tendency to track the economy's underlying growth rate. As real growth picks up, real yields are very likely to follow suit. If the economy upshifts from 2% real growth to 3% real growth, as already seems not only possible but likely, real yields are likely to move to 1% or more. Nominal yields will likely rise by about the same amount, assuming inflation expectations remain relatively stable. If we end up with an investment-led boom that delivers 4% real growth, real yields could easily rise to 2-3%, pushing nominal yields on 10-yr Treasuries to 3.5-4.5% or so. Will that kill the economy? No, because higher yields and a stronger economy go hand in hand. We only need to worry about higher yields when the real and nominal yield curves go flat or invert, because that will be a sign that the Fed is too tight. That's not the case today, and the Fed is taking pains to emphasize that it won't move rates up aggressively.

Chart #4

Chart #4 shows the evolution of the yield curve from 2 to 10 years (the top panel shows 2- and 10-yr Treasury yields, the bottom panel shows the spread between the two). The curve has flattened substantially since early last July (a sign of the bond market's reluctance to embrace stronger growth), but it has steepened by 8 bps so far this week.

Keep an eye on real yields and the slope of the Treasury yield curve. They are excellent barometers of how optimistic the capital markets are about the prospects for stronger economic growth.

And don't worry about the impact of higher yields on the economy—at least not until you start to see the yield curve inverting.

7 comments:

Benjamin Cole said...

As always, superb blogging by Scott Grannis.

In the "Huh?" department:

"Citigroup strategists now see the S&P 500 ending 2018 a modest 4 percent above current levels without much more help from tax cuts.

Tobias Levkovich, Citigroup's chief U.S. equity strategist, had previously based his forecast on a corporate tax rate cut to 25 percent, but he has updated it because the tax bill that is nearing completion slashes the corporate rate to 21 percent.

His year-end S&P target of 2,800 is just shy of the median 2,825 forecast of 13 other equity strategists surveyed by CNBC. The forecast 4 percent gain for 2018, though, appears conservative when compared with the market's 20 percent climb this year."

---30---

4%?

Buy Low then Sell High said...

Scott:

So what is an investor to do in 2018?

WealthMony said...

At least starting in 1981 there has been a very close correlation between the forward earnings yield of the S&P 500 and the yield on the 10-year Treasury Note. In other words, they were consistently about the same, that is, until 1999, when the Treasury yield moved considerably higher than the S&P 500 forward earnings yield (7% vs. 4%). Stocks were seriously overpriced.

That gap closed with the stock market crash in 2000-2002 with the correlation reversing so that the forward earnings yield has since been considerably higher than the 10-year Treasury yield. That could mean either that stocks are seriously undervalued or that Treasuries are seriously overvalued, or that the historical correlation has no significance.

We know almost all valuation methods tell us stocks are overvalued (Shiller CAPEX, Tobins Q, etc) but overvaluations have never determined the immediate direction of the stock market. If you use the Rule of 20 to calculate valuation, stocks are overpriced but by only a modest amount.

I think the stock market is pricey but only modestly so based on a forward PE of ~18 but with an economy that is showing signs of acceleration that could get a more powerful momentum boost from the new tax change, low inflation and low interest rates. I don't think the bull market in stocks will end until the Federal Reserve inverts the yield curve and lays the foundation to drive the US economy into a recession.

Until then I will place my bets on the stock market. And I would keep my eyes on this website because Scott Grannis knows his stuff and his unsolicited "sidekick" Benj is always worth reading. There are others who may very good, informed comments on this site and they do not always agree with Scott. It is rare that he is wrong, but he is a gracious host.

Scott Grannis said...

Re "What is an investor to do in 2018?

It's hard to justify selling, when growth and profits are expected to pick up for at least the next several years and considering how low the yield on cash still is. Some caution is warranted, of course, because rising bond yields will provide more competition for equities.

Benjamin Cole said...

WealthMony-

Thanks for the mention. I like reading what people think, and yes what is the point of being unpleasant?

Sometimes I may have a different point of view than you. So what?

BTW, since we have something close to an efficient market....all guesses are roughly even in value!

Mississippi Snopes said...

Could the bond market's skepticism be driven by something as simple as concerns about the Trump administration's hostility toward international trade and immigration? No changes in tax policy can stimulate the economy if workers are not available to do the work and markets are not available to sell the goods and services.

Scott Grannis said...

Mississippi Snopes: The bond market's apparent skepticism could be due to many things, including Trump's threats to international trade. A global trade war would be devastating not only for the US but also for the global economy.

But it's not just the bond market that is skeptical regarding whether tax reform will result in a stronger economy. We have only one capital market in the US; it makes no sense to say that the stock market is optimistic but the bond market is not. The stock market has gone up because tax reform has caused a one-time increase in the value of future after-tax corporate profits. I think that both the stock and the bond markets still doubt whether tax reform will result in a stronger economy.