Rise in bond yields may force a switch from equities to bonds

Equity markets have reacted negatively to the Federal Reserve (the Fed) announcement, as we signalled a few weeks ago, yet this may be the very start, for reasons discussed herein. Bond yields have risen in reaction to Ben Bernanke’s statements, even though they have been placed in a more soothing context, by William Dudley. However, the fact that bond yields are now high, relative to equity dividends, will be of concern to many asset allocators for many large institutional mandates. We suggest that equities are currently expensive to bonds, and that this situation may result in some changes to asset allocation; from equities into bonds, and to much more volatility in equity prices; something observed in early 2012. More specifically, we cover the following three main topics in the article:

1. A comment on the recent statements by Ben Bernanke
2. A comment on the recent speech by William Dudley
3. An analysis of the relationship between bond yields and equities

1. Recent Fed talk: Bernanke

While the FOMC statement did not contain too many surprises, the press conference did, and the following points are worth making.

First, given that job growth is now averaging 200,000 per month, the Fed has indicated that this is a pleasing development, as Bernake indicates below,

The labor market has continued to improve, with gains in private payroll employment averaging about 200,000 jobs per month over the past six months. Job gains, along with the strengthening housing market, have in turn contributed to increases in consumer confidence and supported household spending. However, at 7.6 percent, the unemployment rate remains elevated, as do rates of underemployment and long term unemployment. Overall, the Committee believes the downside risks to the outlook for the economy and the labor market have diminished since the fall, but we will continue to evaluate economic conditions and risks as they evolve (June 19, 2013 Chairman Bernanke’s Press Conference FINAL, Transcript of Chairman Bernanke’s Press Conference June 19, 2013).

Second, and most concerning, is that inflation is now too low and is trending lower,

Inflation has been running below the Committee’s longer-run objective of 2 percent for some time and has been a bit softer recently. The Committee believes that the recent softness partly reflects transitory factors, and with longer-term inflation expectations remaining stable, the Committee expects inflation to move back towards this 2 percent longer-term objective over time. We will, however, be closely monitoring these developments as well (June 19, 2013 Chairman Bernanke’s Press Conference FINAL, Transcript of Chairman Bernanke’s Press Conference June 19, 2013).

Third, a moderation of quantitative easing may be appropriate, depending on the forthcoming data releases. Given the improvement in the labour market, and despite the disinflation that is apparent, the FOMC is now looking at winding back the pace of fixed income purchases,

If the incoming data is broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year. And if the subsequent data remains broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around midyear (June 19, 2013 Chairman Bernanke’s Press Conference FINAL, Transcript of Chairman Bernanke’s Press Conference June 19, 2013).

Markets have read these statements as meaning that the Fed has a schedule that it will pursue, regardless of developments in the economy; between now and the northern hemisphere autumn. However, permanent voting member, Dudley, has recently put the record straight, as we now discuss.

2. Recent Fed talk: Dudley

After a series of sobering observations about the size of the recession and the slowness and shallowness of the recovery, Dudley concludes with the following summary,

Thus, I continue to see the economy as being in a tug-of-war between fiscal drag and underlying fundamental improvement, with a great deal of uncertainty over which force will prevail in the near-term. This tug-of-war is clearly seen in the monthly employment data. Over April and May, the average monthly gain in employment in the private service-providing sector has been well maintained at 175,000. In contrast, employment in the manufacturing sector and the federal government declined a combined 20,000 per month. And the resulting uncertainty is, I believe, an important contributing factor behind the relatively sluggish pace of business investment spending (Are Recent College Graduates Finding Good Jobs? June 27, 2013, William C. Dudley, President and Chief Executive Officer).

The Fed can make forecasts, but it, like the market, has been overly optimistic in the past. This tendency towards overly optimistic expectations is to be expected, as market participants keep assessing the recession in the context of prior recessions. However, the recent recession is very different, it is the “great recession”, as Dudley terms it. When we exit this period, the historians will view the current periods as a something close to a depression, which was never acknowledged, as such, during the time,

Here, a few points deserve emphasis. First, the FOMC’s policy depends on the progress we make towards our objectives. This means that the policy—including the pace of asset purchases—depends on the outlook rather than the calendar. The scenario I outlined above is only that—one possible outcome. Economic circumstances could diverge significantly from the FOMC’s expectations. If labor market conditions and the economy’s growth momentum were to be less favorable than in the FOMC’s outlook—and this is what has happened in recent years—I would expect that the asset purchases would continue at a higher pace for longer [emphasis added] (Are Recent College Graduates Finding Good Jobs?, June 27, 2013, William C. Dudley, President and Chief Executive Officer).

Growth is not just proceeding, in an unimpeded fashion, but a “tug-of-war” is going on, which helps explain the underlying dynamics in the US as Dudley indicates,

Finally, I believe this tug-of-war analogy is useful in explaining the recent inflation dynamics. As is well known, total inflation, as measured by the personal consumption expenditures (PCE) deflator, has slowed sharply over the past year and is now running below the FOMC’s expressed goal of 2 percent. Much of the slowing of total inflation is due to declining energy prices resulting from the weakening of global growth mentioned earlier combined with increased energy production here in the U.S. However, it is also the case that core inflation, that is, excluding food and energy, has slowed sharply as well. A decomposition of the slowing in core inflation reveals that some of it is due to slowing in the rate of increase in prices of non-food and non-energy goods. This probably is due in large part to the softening of global demand for goods and the modest appreciation of the dollar that has occurred since mid-2011.

Most of the decline in inflation is energy and USD related, yet the interesting comment is about service sector inflation, especially medical and financial services. Service inflation should tend to slow in an environment with an oversupply of labour, and that is exactly what we have got, at this time, as Dudley indicates,

In the service sector, the rate of increase in prices of medical services and “non-market” services—the latter includes some financial services—also has slowed notably recently. In contrast, the rate of increase in prices for other non-energy services has been relatively stable. Comparing this set of conditions to that in 2010, the recent slowing of inflation has been less widespread across core goods and core services, and inflation expectations so far have declined less appreciably than they did in 2010. Thus, my best guess is that core goods prices will begin to firm in the months ahead as global demand begins to strengthen and inventories get into better alignment with sales [emphasis added] (Are Recent College Graduates Finding Good Jobs?, June 27, 2013, William C. Dudley, President and Chief Executive Officer).

Market implied tightening remains “out of sync” not only with published statements by the Fed, but also the expectations of most Fed members,

Some commentators have interpreted the recent shift in the market-implied path of short-term interest rates as indicating that market participants now expect the first increases in the federal funds rate target to come much earlier than previously thought. Setting aside whether this is the correct interpretation of recent price moves, let me emphasize that such an expectation would be quite out of sync with both FOMC statements and the expectations of most FOMC participants [emphasis added] (Are Recent College Graduates Finding Good Jobs?, June 27, 2013, William C. Dudley, President and Chief Executive Officer).

3. An analysis of the relationship between bond yields and equities

All this “Fed talk” has very significant implications for asset allocation, as bond yields have now risen significantly, where US 30 year bonds are now around 3.50%; up from the high 2% levels. What generally happens when bond yields rise is that that investors switch asset classes, from the lower yielding equities, to the higher yielding 30 year government bond.

We begin our analysis from a longer term perspective. Here, if you look at equities as another form of yield investment, then you can compare the yield on equities, as obtained through dividends, and the yield on a longer government bond, as shown in Figure 1 below, with equity yields presented by the dark blue line and 30 year US bond yields presented as the light blue line,

Figure 1

Looking at equities from a yield perspective might be considered unusual, yet this perspective, despite the drawbacks, really helps with comparing one asset class to another, as yield measures return for risk borne in each asset class. Notice how yields on equities jump in a crisis, since the price of equities falls, while the dividend remains much the same, as the opposite occurs with bond yields.

Assessing more recent performance, we show the ratio of the 30 year government bond yield to the S&P 500 dividend yield. For example, the current 30 year bond rate is roughly 3.50% and the current equity dividend is roughly 2.13%, so the current ratio is 1.64; the 30 year government bond yields 1.64 times the S&P dividend, excluding the potential for the equity dividend to grow in line with the economy.

Now, if we calculate this ratio back until the time we saw a large reduction in equity prices, we find that the current ratio is fast approaching levels last seen when a switch between equities and bonds occurred; back in March 2012. Here, a rise in bond yields, among other things, may have forced asset allocators to switch back from equities to bonds. Here, 30 yr treasuries sold from the high 2% range, to roughly 3.50%, much the same as they have recently, so that bond yields looked relatively cheap, when compared to the equity yield. In order to gauge the relative attractiveness of bonds, to equities, we divide the US 30 year bond yield by the equity yield on the S&P 500, which is provided by the dark blue line on the left hand axis on Figure 2 below, while the S&P 500 equity index level is provided by the light blue line, on the right hand axis of Figure 2 below,

Figure 2

Even though one might argue that the bond market may well have overreacted to the recent Fed discussion, as the Dudley comments tend to suggests, that is really not the point. Rather, the fact remains that bond yields are now high; they are at a level that has been damaging for equities in the past, as equities now fail to present sufficient yield to justify continued asset allocation. This, among other things, such as the ongoing fiscal drag and emerging European deflation, posses threats to equities at this time.

Conclusion

As we foreshadowed some time ago, the Bernanke speech was not going to be a positive for equities. However, the surprising thing is that fixed rate bonds have also suffered, although the Dudley remarks of late suggest that the rise in yields has been overdone, and we tend to agree with Dudley. However, higher long bond rates create a real problem for US equities. Long bonds appear cheap to equities, and last time this happened, equities were sold to purchase bonds. In other words, we have only just begun a volatile period for equities; a period where higher bond weights make sense, especially given the recent rise in longer rates.