The sharp rally in 10-year U.S. Treasury yields seen since the start of May has pushed government bond yields above the average dividend yield for U.S. equities, removing one of the strongest tailwinds supporting the rally that took the S&P 500 to new all-time highs (Chart 1). Conventional wisdom dictates that this should be a negative for stocks, as the yield gap between debt and equities generally favors the riskier equity assets. In addition, higher yields translate into higher corporate borrowing costs, which act as a drag on economic growth and puts pressure to equity prices. When viewed in this context, the bull market in equities may be facing some headwinds going forward.
What’s missing from the “conventional” wisdom above is the source of the rising yields, as there are numerous reasons for bond yields to rise. In the current context, yields are rising from an exceptionally low starting point, one that was designed to breathe life into a listless economy, and rescue a housing market from a devastating crash. With that in mind, rising yields are an indication of an economy that is picking up speed, which is hardly a negative for corporate earnings and by extension, equity valuations. Beyond a certain point, however, rising yields do start to act as a drag on the economy.
Based on our quantitative study of the relationship between 10-year nominal U.S. Treasury yields and the price-earnings ratio of the S&P 500 Composite Index, that tipping point is around 5%-6% (Chart 2). The red asterisk on Chart 2 indicates the current 10-year Treasury yield and the current S&P 500 p/e ratio. If the historical relationship between government bond yields and equity valuations holds, and Treasury yields continue to rise, so should equities – up to a point.
Whether yields continue to rise, however, is far from assured. The current rally, at its peak on June 25, took the 10-year Treasury yield over 30% above its 50-day moving average, the largest relative rally in at least 50 years (Chart 3). Given the extent of the rally, it may well be overextended.