A sharp drop in interest rates has traditionally been a negative for stocks. The chart below shows that most significant declines in 10-year yields over the years were associated with steep drops in the S&P 500. Usually, equity losses precipitated the drops in yield. As stock declines accelerate, money flows into bonds — raising prices and depressing yields. The crashes of 2000-2003 and 2007-2009 are striking examples. So are the corrections of 2010, 2011, 2015 and 2016.
There were several exceptions, when stocks were supported through carry trades and other algo-stroking forces: the 15% rise in SPX between Dec 2013 and Feb 2015, the minor 6.1% drop between Mar and Jul 2016, and the 2.5% rise between Mar and Sep 2017.
But, significantly, not a single equity correction occurred without a concurrent and significant drop in yields. This begs the question, then, of whether increases in yields are positive for stocks.
In 2008, yields bottomed almost 2 months before stocks did in 2009. But, in the 2000-2003 crash, yields bottomed 9 months after stocks. Most other yield rallies from significant bottoms also lagged stocks: 4 months in Oct 2010, 9 months in Jul 2012, 3 months in Jan 2015, 5 months in Jul 2016.
It would seem at least some bond buyers take a “show me” approach, waiting until the coast is clear in equities before shifting money back into bonds. This analysis ignores the considerable influence that Fed purchases had on bond yields — an influence which the Fed maintains will diminish over the next few years.
So, what are we to make of the latest spike in yields which began on Sep 7, 2017? The 10Y rose from 2.03% to 2.94% through Feb 21. SPX rallied along with it, up almost 17% by Jan 26 — then promptly did a gut wrenching 11.8% nosedive in only 2 weeks.
Fortunately for the bulls, it got a strong bounce off its 200-day moving average and subsequently bounced to its 61.8% retracement. But, pundits seem fixated on the 10Y with rates nudging up against 3%. Does it matter?
In a word, yes. Even though 3% is still well below historical yields, the level of debt has risen dramatically over the years. The chart below shows the annual interest expense (the orange line) and the US’ rapidly growing pile of debt. Superimposed over each is the average interest rate (the black line) paid on that debt.
Even though interest rates have flatlined since 2013, the expense of servicing the rapidly expanding debt has risen sharply — recently breaking out to all-time highs.
Clearly, if rates were to normalize the interest expense would be unmanageable. How unmanageable, you ask?
Between 2000 and 2007, the average interest rate was 4.84%. On the current $20.6 trillion balance, that would mean an annual interest expense of roughly $1 trillion. And, we haven’t even begun to talk about the effect on consumer debt, the mortgage market, debt issued to fund corporate buybacks, etc.
Obviously, an increase in the 10Y yield doesn’t immediately reprice the entire pile of debt. But, it’s a clear step in the wrong direction. And, investors are right to be concerned. I imagine the Fed is also quite concerned — which is why I put a target of 2.85% on the 10Y back on Jan 10 [see: China – It’s Not Me, It’s You.]
Not only did it represent channel and Fib resistance, but it seemed like a good tipping point for what I expected to be rising concern (one can hope) about our shaky fiscal situation. TNX overshot it a little, which has been fairly common over the years (Feb 2011, Sep and Dec 2013, etc.)
Those previous overshoots typically helped stocks get past resistance. It might work this time, too. But, judging from the mood out there, I don’t believe stocks will be led higher by higher interest yields this time. And, I have trouble believing the Fed isn’t working to put a lid on long rates – yield curve be damned.
* * *
Where To Next?
The End is (Probably) Near
CPI: The Charade Continues
Update on Bonds: Jan 29, 2018
Interest rates rose in the early 1930s during the stock market crash. There was an international currency crisis and major trade wars too! Looks like we are heading in the same direction over the next few years.
Yes, there are many parallels. Though, central banks clearly have many more tools at their disposal with which to manipulate stocks and bonds. They have perfected these over the past five years; but, it doesn’t seem they’ve really been tested since the GFC. Glad you mention the trade situation, which represents a significant risk to the extraordinary cooperation between central banks.