Trigger points loom over stock markets

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There is a feeling that government bond yields, after falling for 40 years, could resume an upward trend. There are three reasons why this may be bad news for stocks. The year did not start well for the stock markets. Fears of inflation and monetary policy tightening weigh on stock prices as tensions between Russia and Ukraine cloud the outlook.

Third, stock valuations are tied to expectations of future earnings growth. To put a present value on these future benefits, they must be discounted by some rate to account for the time value of money – a dollar in 10 years is worth less than a dollar today. This rate is usually the yield that could be predictably obtained elsewhere, usually benchmark bond yields. Lower bond yields mean a lower discount rate and therefore seem to justify a higher level of valuation. On the other hand, higher bond yields should translate into lower equity valuations.

The first is that for asset allocators, bonds and stocks are competing options. Higher yields make bonds more attractive and tempt some investors away from equities. The second reason is that higher bond yields make it harder for the economy to grow and more expensive for companies to raise funds.

The valuation problem is perhaps the biggest threat to the stock market since the cyclically-adjusted price-to-earnings ratio (which compares stock prices to the average earnings of the past 10 years) on Wall Street is nearly 40 , more than double the historical average. Furthermore, the valuation of technology stocks is based in particular on the profits still to be made, so they are more clearly penalized by a rise in the discount rate.

But the market damage has so far been limited. Is there a trigger point where the level of short-term bond yields leads to a more calamitous fall in stock prices? History gives us some clues. The yield on 10-year Treasury bonds peaked at around 15.8% in September 1981 before falling steadily to less than 0.6% in July 2020. But this decline was punctuated by half a dozen periods in during which the yield jumped.

In 1987, for example, the 10-year yield rose from 7.2% at the end of February to 9.6% at the end of September. This was followed by “Black Monday” in October 1987, when the Dow Jones Industrial Average fell more than 22% in a single day.

In the late 1990s, the yield rose from 4.4% at the end of September 1998 to 6.4% at the end of February 2000. Soon after, the dotcom bubble began to collapse. What about the great financial crisis of 2007-2008? The evidence is less clear. The yield on 10-year bonds fell from 3.4% in May 2003 to 5.1% in May 2006, but the first signs of stress in the financial system only really appeared in April 2007, when the mortgage lender New Century went bankrupt.

But the debate is complicated by the existence of a second trigger point built into the markets. As yields increase, they cause economic and financial damage. At some point, central banks may decide that the damage is sufficient to justify an end to monetary tightening. Indeed, even before central banks change course, investors can anticipate that they will be forced to do so. This could cause them to start buying both government bonds and stocks in hopes of monetary easing.

Making an accurate call on the level of bond yields that would now be needed to cause serious trouble is made more difficult by their falling level. The 10-year yield has more than doubled since the 2020 low, but that only implied a rise of just over a percentage point. In the 1980s and 1990s, it seems that it took increases of more than two percentage points in yield to cause significant problems. This suggests that a 10-year yield of 2.5-3% would be the crucial level.

Over the past cycle, the Federal Reserve’s benchmark federal funds rate peaked at 2.25-2.5%. In late July 2019, the Fed cut rates citing “global developments” and “subdued inflationary pressures”. But inflation now sits at 7% in the United States and the Fed must surely continue to increase until it is brought under control.

Bulls will think that any upward movement in bond yields and interest rates will be temporary as inflation will eventually come down. It will be possible to overcome any short-term turbulence. But bears will believe it will be impossible for the Fed to control inflation without inflicting serious damage to the economy and markets.

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