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US Equities and Bond Yields : To Go Their Separate Ways?

Some commentators are concerned about the impact of rising bond yields on US equities, thereby suggesting the imminent return to a negative correlation between equity prices and bond yields. Deflationary psychology will, however, need to be properly slayed before the aforementioned backdrop reappears.

Deflation can produce long-lasting scars in both the real economy and financial markets, as testified by the experience of Japan during its balance sheet recession that lasted sixteen years from 1990 to 2006. Meanwhile, the US has experienced deflationary psychology since 2000, but the sheer severity of its 2007-2009 balance sheet recession sowed the seeds for an increase in inflationary expectations during the subsequent recovery.

The reflationary policies promised by the incoming Trump Administration were initially seen by bond investors as a route to escape the clutches of the “new normal.” Meanwhile, the Federal Open Market Committee (FOMC) has lowered its estimate for the non-inflationary speed limit for the economy, thereby producing a hawkish policy reaction function. The damage to bond yields has, however, been limited due to the persistence of low inflation.

Financial market measures of inflationary expectations exhibit mean reversion characteristics and the current five-year measure embedded in Treasury Inflation Protected Securities is 1.9%, just below its fourteen year average of 2.3%. Survey-based measures of consumers’ inflationary expectations have been stable in 2017, either suggesting continued confidence in the anti-inflation credibility of the Fed or growing scepticism about undiluted fiscal reflation by the Trump Administration.

US equities appear to enjoy a sizeable valuation attraction compared to bonds, as measured by expected real returns, thereby suggesting a safety buffer should yields back up. Investors need to assess the risks of an overshooting of yields back to pre-Great Recession levels as the Fed shrinks its balance sheet.

Higher bond yields have not been detrimental to US equities due to better corporate profit expectations since the US Presidential Election. There is, however, a limit to how much higher profits, attributable to enhanced pricing power, can offset rising bond yields, because mounting inflation will ultimately reduce the quality of corporate profits, thereby necessitating P/E multiple compression.