Stocks are cheap if Fed controls the yield curve

More and more, investors and analysts are justifying the records in the S&P 500 Index and the technology-focused Nasdaq 100 in the context of interest rates, which is ordinarily the domain of bond traders. Strategists at Bank of America Corp. attributed about 16% of the outperformance in technology stocks in recent years to falling bond yields; that's a record high and more than twice the level observed before the 2008 financial crisis. The earnings yields on the S&P 500 and Nasdaq 100, which measure profit relative to share price, might be at the lowest levels since the early 2000s, but they're still 296 basis points and 184 basis points more than the benchmark 10-year Treasury yield, respectively.

Even trailing 12-month dividend yields look compelling: 1.69% on the S&P 500 and 0.71% on the Nasdaq 100, compared with 0.65% for the 10-year Treasury note. And those rates aren't skewed by a few companies: About 78% of individual stocks in the S&P 500 have a dividend yield that exceeds the 10-year U.S. yield, an all-time high and compared with an average of 25% in the past two decades, according to Russ Certo at Brean Capital.

All of this is to say: In many ways, it's still possible to claim that stocks are cheap. But only if you believe the Federal Reserve will keep tight control over the yield curve.

On Aug. 6, the 10-year Treasury yield fell to as low as 0.5%. Three weeks later, the yield touched 0.79% - still low by any historical measure, but suddenly higher than the dividend yield on the Nasdaq 100 by the most since before the coronavirus pandemic took hold in America. The only other time this relationship reversed was in early June, when 10-year Treasury yields were heading toward 1%. After that, stocks swiftly sold off and yields fell back in line.

That precedent was enough to make JPMorgan Chase & Co. strategists nervous. "With the long end of the curve already threatening a confluence of threshold signals for yields to break higher, continued price weakness has the potential to trigger another flow of momentum based selling pressure," said Peng Cheng, a JPMorgan global quantitative and derivatives strategist. Bloomberg News's Ven Ram wrote this week that "Treasury Yields Will Become a Headache for Stocks Around 1%."

This time around, however, U.S. yields tumbled back into their range while the stock-market rally pushed forward unperturbed. What happened?

The Fed tipped its hand.

For evidence, look no further than the move in 10-year Treasurys on Sept. 1, from a yield of 0.73% at 10:30 a.m. in New York to 0.67% by 3 p.m. There was no bad economic news; in fact, Institute for Supply Management data showed U.S. manufacturing expanded in August at the fastest pace since late 2018. It was hardly a risk-off day, either, with the S&P 500 advancing by 0.75% and a Bloomberg Barclays index of high-yield bonds gaining for the eighth consecutive session.

Instead, it all boiled down to the central bank. First, the Fed bought $1.73 billion of 20- to 30-year Treasury bonds in its daily purchase operation, immediately driving down longer-term yields. Then, Fed Governor Lael Brainard discussed the central bank's new policy statement, following speeches from Chair Jerome Powell and Vice Chair Richard Clarida.

"In coming months, it will be important for monetary policy to pivot from stabilization to accommodation," Brainard said. "While the Committee did not anticipate the unprecedented challenge of the Covid-19 pandemic when the review was launched, the new statement puts us in a stronger position to support a full and timely recovery."

Most obviously, this is a nod toward a form of explicit forward guidance that ties future interest-rate increases to actual inflation that exceeds the central bank's 2% target. But it could also be seen as foreshadowing a more tactical round of quantitative easing, perhaps in the same mold as Operation Twist in 2011. The Fed's official line on the program at the time, after all, was that it should "put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative." 

One of the last remaining points of intrigue among Fed watchers is how officials would react to rising long-term Treasury yields. In general, I tend to think central bankers would tolerate a modestly steeper yield curve if it was happening for the "right reasons," like a pickup in inflation or signs of a more robust economic recovery. It would certainly be a lifeline for the banking industry. But, as my Bloomberg Opinion colleague Tim Duy has said, Powell and his colleagues have also been begging Congress for additional fiscal stimulus to support the economy, and rock-bottom borrowing costs make that an easier sell on Capitol Hill. Then again, if low Treasury yields are pushing the stock market to record highs, which in turn dials back lawmakers' urgency to pass a new round of relief, which harms the economic recovery, then that brings everything back to square one. And around and around it goes.

An alternative way to measure the appeal of equities relative to bonds is looking at how the two markets treat the same company, which incorporates credit risk into the equation. Consider one poster child for an overpriced tech titan: Apple Inc. Even though its share price has more than doubled in the past six months, it doesn't look wildly overvalued in a fixed-income context. The iPhone maker issued five-year securities last month that pay a 0.55% interest rate. That's far below its current earnings yield of 2.45%, and somehow even less than its dividend yield of 0.6%.

Now, it's not quite such a simple calculation. While Apple will pay its bondholders their initial investment upon maturity, its shares offer no such promise. In theory, the company could stumble and leave investors saddled with a steep loss. A bond's yield is a guaranteed nominal return if the security is held to maturity (defaults notwithstanding). A stock's earnings yield is just the inverse of the price-to-earnings ratio. Dividends can also rise or fall in a hurry - globally, payouts dropped in the second quarter by the most since 2009.

Regardless, the stock market appears to be all-in on the Fed keeping the long end of the U.S. yield curve in check. This week's moves "can be chalked up to the market's faith that the Fed will not hesitate to offer additional accommodation in aggressive fashion," BMO Capital Markets strategists Ian Lyngen, Jon Hill and Ben Jeffery wrote. "There is limited scope for risk assets to fall in the very near term."

In other words, it all comes down to yields. And from that vantage point, even after this unprecedented run, stocks still offer better value than bonds. For better or worse, that doesn't seem likely to change until the Fed says so.

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Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.