Investors groping for a bottom to the current bear market in stocks are searching in all the wrong places. Some are obsessing over the Federal Reserve's overnight rate policy. Some are perusing company results. Some are worrying over a potential recession. Still others are watching technical indicators to signal a washout bottom. But these are not the best trees to be barking up. Investor attention today should be focused instead on long-term Treasury yields. If these go up, stocks go down. When these rates stabilize, stocks resume their climb.
The link between long Treasury yields and stock prices is not just an historical correlation. It is causal. The stock market and the Treasury market are the two most liquid markets in the world. Stocks and bonds are arbitraged with each other minute by minute every trading session. As yields on risk-free Treasuries become more attractive, stocks become less attractive. Investors at the margin sell the Apples and Microsofts to buy Treasuries, driving down stock indexes.
Treasury bond yields are the de facto discount rate for the stock market. When the discount rate goes up, the net present value of future cash flows goes down, even if there is no change to “fundamentals.” The most powerful market tool in the Fed's arsenal today, therefore, is to reduce Treasury re-purchases that artificially suppress rates.
Those who think the cessation of QE (Quantitative Easing) in March put a stop to the Federal Reserve as the biggest buyer of Treasury issuances are mistaken. The Fed’s holdings of Treasury bonds have become so large now that simply re-investing the proceeds of maturations back into Treasuries preserves this dubious distinction. Monthly Treasury purchases by the Fed still exceed $100 billion just to keep the balance sheet from shrinking.
The Fed has indicated they will begin QT (Quantitative Tightening) with only a $30 billion reduction in monthly re-purchases starting in mid-June, rising to a $60 billion monthly reduction by mid-September. Once this policy is implemented, Treasury prices may start to fall in response to the reduction in demand, eventually driving yields toward the 4-5% range. Although the Fed and the ECB for that matter had no problem purchasing sovereign bonds at a negative real yield to achieve policy objectives, a profit-seeking purchaser in an unfettered bond market is unlikely to agree to commit money to a 3% nominal return if inflation is 4%. The yield on the 10-year German bund is now a positive 1.5% instead of negative as it has been for years, robbing the US Treasury bond market of an additional enthusiastic buyer of uneconomic securities.
When free reign is finally restored at least partially to price discovery in the Treasury market, Treasury bond investors can be expected to demand a nominal rate that fully compensates for inflation and then some. If inflation expectations fall to 3%, for instance, bond investors may demand a nominal rate of 4%. Alternatively, if inflation expectations only fall to 4%, then bond investors may demand a 5% nominal rate. Note that even a 4% rate is still twice the yield that these securities have offered over the past few years.
The return to a real rate of return accounts for the difference. In other words, even if inflation returns to 3% next year (optimistic), we are not going to see Treasury rates nearly as low as we have become accustomed to. The cost of capital is permanently higher without government intervention, (so don’t expect PEs to reach prior peaks either.) Treasury bond rates were indeed 4-5% before QE was implemented during the Financial crisis, when inflation was not even an issue. Today’s rates should arguably be at least that given even optimistic views on today’s inflation prospects.
What would 4-5% Treasury bond rates do to the stock market? It would not be pretty. An increase in the 10-year rate from 1.6% at the beginning of this year to 3.3% today has driven the S&P 500 index down more than 20%. It is hard to imagine that a further increase to 4%-5% does not lead to more significant market declines.
The million-dollar question is: How much of the pending increase in long Treasury rates is already priced into stocks? The answer seems to be: not much. The PE of the stock market was 14X when it bottomed in 2018, before the Fed massively expanded its balance sheet from $4 trillion to $9 trillion. A PE of 14X applied to forward S&P 500 earnings today of $229 would imply a target for the S&P 500 index of 3200, i.e., a further 15% decline from today. Companies with the biggest market capitalizations in the stock market, like Apple and Microsoft, trade at 22X forward PE. The biggest constituents of the market, these have a lot of room to fall before they come close to a market multiple. Another big-cap tech constituent, Amazon, trades at twice that valuation so has even further to fall.
Although the Fed started taking action against inflation eight months ago, their first reduction in Treasury re-purchases is not even scheduled to start until this week. This is the nuclear option, the most potent weapon in their arsenal for impacting stock prices.
It’s about time. Hold onto your hats. The Fed is not on your side.