In recent weeks, prior to the latest banking scare regarding the collapse of Silicon Valley Bank, the benchmark US ten-year Treasury bond yield had exceeded 4.0% while the interest rate-sensitive two-year bond yield had pushed above 5.0%. Since then, bond yields have fallen sharply, indicating expectations that the Federal Reserve will hold off further sharp rate rises in order to quell fears about regional banking failures. And yet the story about the bond market and the share market holding to different narratives remains largely the same – each market appears to be captive to different expectations.
Bond yield curves usually slope upwards as investors normally expect a higher return for committing their funds for the longer term. The yield curve is inverted which means shorter term bonds deliver higher annualised returns to investors – and have been for some time. However, an inversion over 1.0% is exceptional and is often (but not always) a warning sign that the economy is heading for recession.
The higher short-term bond yield reflects near-term interest rate expectations (currently high and rising) while longer term bond yields are lower, reflecting reduced future interest rate expectations (anticipated to peak in coming months). This could reflect fears that high interest rates will cause a recession or an extended slowdown that will subsequently require central banks to cut rates and keep them lower for some years.
Meanwhile, the share market appears more optimistic as it focuses on the strong labour market and robust consumer spending.
The Bloomberg chart below shows the “equity risk premium” over the last 25 years. For the last decade, the earnings yield on S&P 500 stocks were at a healthy premium to the yield offered by inflation adjusted 10 year Treasury bonds. But as illustrated, that yield premium has steadily fallen, largely driven by rising bond yields. The chart implies that stocks are at their least attractive level relative to bonds since the height of the GFC in 2009.
Which is right, the bond market or the share market?
Only time will tell. There is sufficient uncertainty that the prudent investor will arrange their portfolio so that it will be resilient under any reasonably likely economic outcome.
However, it does appear that the equity market has not yet sufficiently reflected the risk of a slowdown on companies – especially those which are sensitive to consumer spending. This has so far been supported by elevated levels of household savings which built up during Covid, but the rundown in household savings can only support spending for so long.
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