Something Has Got To Give

19 Apr 2016

OVERVIEW

  • The S&P 500 stock index has staged a remarkable recovery in recent weeks and is now a bit higher on the year, while 10-year Treasury yields continue to languish at low levels.
  • Equity prices are being supported in part by expectations that the Federal Reserve will deliver very little policy tightening in order to keep growth close to trend. This boosts the present value of expected stock dividends and supports equities, even if the growth outlook remains unchanged or has improved only marginally.
  • However, most of the decline in bond prices appears due to a decline in the term premium, not the expected rate path. Expectations for global quantitative easing and a reduction in economic and policy uncertainty are the main factors that have driven the term premium lower.
  • While the divergence between equity prices and bond yields may persist, term-premium induced declines in rates can be unstable and prone to reversal. Central bank communications errors or reduced expectations for global quantitative easing could lead to a “snapback” in the term premium.

THE PUZZLE

One of the more striking developments of recent weeks has been the divergence between US stock prices and long-term Treasury yields. After moving in the same direction earlier in the year, equity prices and bond yields have since parted company. Looking through the ups and downs in performance, the S&P 500 index is slightly higher on the year while bond yields are back down close to their 2016 lows, with 5- and 10-year yields both over 40 basis points lower than where they started the year.

What macro outlook do investors have in mind that leads to notably lower bond yields but higher equity prices? Addressing this question is not merely an academic exercise. Two occasions in early 2015 also saw signi cant declines in bond yields but resilient equities, and in both cases stocks held gains but yields eventually snapped higher. Current relative pricing of bonds and stocks may eventually resolve in a similar matter. Or perhaps bond markets are signaling a less favorable outlook, and equities will sooner or later re ect the same, especially
if the narrative of ineffective policy returns to the fore. Of course, the factors underlying low bond yields and resilient equities could persist, perhaps even leading to further equity gains while yields stay at very low levels. Our goal in this brief note is not so much to call the outlook for bonds and equities, but to provide a framework for thinking through the issue from an economic perspective.

Discounting the Future

Long-term government bond yields and stock prices are closely linked. The yield on long-term government bonds provides a sensible discount rate for equity investors looking to place a value today on the stream of future dividends. Holding all else fixed, equities should rally when long-term bond yields decline as the future dividend stream is discounted at a lower rate. However, bond yields fall for a reason and the change in world view that leads to a reassessment of the fair value of risk-free rates will often have implications for the capacity of the corporate sector to generate dividends. If the outlook for the global economy deteriorates then investors will be revising down their forecasts for future dividends as well as the future path of policy, and stocks will probably sell off despite the lower discount rate. Solving our puzzle therefore boils down to understanding the reasons why investors have re-priced US Treasuries and whether that revised world view has implications for equity valuations.

A Yield Decomposition Framework – the expected path of rates and the term premium

To shed light on the reasons for the rally in the bond market we decompose long-term Treasury yields into the risk-neutral yield (the expected path of short-term rates) and the term premium (the extra compensation that investors demand for holding a longer-term fixed income asset). We take this approach because if we can identify which component has moved lower and why, it could provide insights into investor sentiment towards equities.

We draw two tentative conclusions when applying our framework to bond yields. First, some portion of recent bond and equity developments reflects investors pricing in a view that a lower path of short-term policy rates will be required (and delivered) to sustain growth. In addition, investors may have now a somewhat more optimistic assessment of the growth outlook relative to the one they held at the beginning of the year. Thus equities have been supported not only by a lower discount rate but possibly also by an improved medium-term outlook.

Second, a substantial portion of the decline in long-term yields is due to a decline in the term premium. This could be due to global quantitative easing (QE), reduced economic uncertainty, a decline in the inflation risk premium and risk aversion. None of these explanations are entirely convincing on their own, and while all may be playing a role, arguably global QE and reduced economic and policy uncertainty provide the most compelling explanations for the fall in the term premium (as well as the improvement in risk asset performance).

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