The stock market holds this truth to be self-evident: that higher interest rates are bad for equities. If the government is offering you a sweet, “risk-free” yield for your hard-earned cash, you’ll naturally be more inclined to take it than try your chances at stocks, where nothing is guaranteed. The opposite, low interest rates, means there’s a small opportunity cost to tying up your money in equities. Indeed, the Federal Reserve’s three-plus-year emergency interest rate policy, combined with rounds of quantitative easing, has brought Treasury yields across the curve down to negative levels, in real terms—and by design. Save and you lose. Banks these days feel they are doing you a favor by paying you pennies for your cash. Ben Bernanke, for all his common-manliness, wants it that way. Unfair, you say? Then buy a house, car, or factory. And 100 shares of General Motors while you’re at it.
Surprising then that Standard & Poor’s just issued a report that posits an opportunistic coexistence between a rising stock market and rising interest rates. It’s kind of like mutually despising Van Halen frontmen David Lee Roth and Sammy Hagar staging a limited rapprochement.
According to the S&P analysis, going back to 1953, U.S. stocks actually posted their best returns when 10-year Treasury yields rose to almost 4 percent. The S&P 500-stock index gained on average 1.7 percent a month during periods when 10-year yields climbed to a range of 3 percent to 4 percent. When yields exceeded 6 percent, stocks would finally cry uncle and start losing money.
“The ‘sweet spot’ for equity prices appears to be a rising rate environment between 3 percent and 4 percent, as a growing economy reduces unemployment while increasing corporate earnings, yet does not trigger growth-slowing efforts by the central bank,” explained Sam Stovall, S&P’s chief equity strategist, in the Monday report.
Indeed, stocks rallied last week just as 10-year bond yields had their biggest weekly spike in eight months. “Rising rates,” wrote Stovall, “could offer a catalyst to equity prices, as new cash from fleeing bond investors seeks a new home.”
To a certain extent, this all flies in the face of one Wall Street interpretation of “crowding out”: No one on the planet—not Apple, not the Chinese—can compete with a multi-trillion-dollar Uncle Sam bent on raising money. He can sweeten the yield pot more than any private player can. Three decades ago, with the government jacking up rates to fight inflation, Treasuries yielded in the teens and banks gave you toasters and blenders to further induce you to open up a generously yielding CD. In 1979, the cover of this fine magazine infamously declared the “Death of Equities: How Inflation Is Destroying the Stock Market.” Unimpressed, said stock market went on to have its best two-decade run in history. Bonds, for their part, staged an unprecedented 30-year rally. (See chart, above.)
Toggle over to the spring of 2007, with the economy and Wall Street in apparent—and fatal—full bloom. The 10-year Treasury was yielding nearly 5 percent. Of course, that was chump change compared with the riches promised by investing in private equity, emerging markets, and subprime liar loans. Until, of course, it wasn’t, and everyone piled into the safety of government bonds as the system came unglued.
Now, with the economy seemingly recuperating and markets at multi-year highs, competition for dormant dollars is back. People will again demand return on capital over return of capital. You could well look like a horse’s ass for lending the over-indebted government 10-year money for a bit over two points while the Dow Jones industrial average is not far from its all-time high. Shame on you if you accepted a 1.7 percent coupon on a 10-year during September’s short-lived global market panic; that yield is now up to 2.3 percent. If rates keep shooting higher, you’ll have to take a huge hit trying to offload your mistake-trade of 2011. Time is money.
The element of timing looms large. If Bernanke finally changed his mind and decided he needed to tighten the rate spigot, the economy would see a last-call race to investment. As mortgage rates jumped, on-the-fence home buyers could be compelled to hurry up and get it while the going’s cheap. Bond investors, meanwhile, would take a hit, and need to move their money elsewhere. Writ large, normal—non-emergency, non-negative—rate policy telegraphs to the world that the Fed feels confident enough in the economy to be readying the patient for discharge.
And you will start to see headlines like this gem: Goldman Sachs, still smarting from l’affaire Greg Smith, declares that the relative prospects for stocks are “as good as they have been in a generation.”
“Given current valuations, we think it’s time to say a ‘long goodbye’ to bonds, and embrace the ‘long good buy’ for equities as we expect them to embark on an upward trend over the next few years,” wrote Peter Oppenheimer, Goldman’s chief global equity strategist, in a report Wednesday.
In other words, the Death of Bonds.