What The Move In Treasuries Means For Equities
Today Alan Greenspan wrapped up his two day testimony to Congress regarding
his assessment of the US economy. Although the Chairman of the Federal Reserve
was optimistic that a full-fledged economic recovery would come to fruition, he
was unable to manipulate the Treasury market to keep the rally inÂ
government bonds going–as he was able to do in May. As a consequence, yields
have shot up across the curve, and the yield on the 10 year note
(
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now at 3.950%, which is slightly higher than where it was at the beginning of
May before the Fed issued its directive targeting prices and economic growth
separately.
Indeed it is normal for yields to rise during economic up-cycles, in
anticipation of rising inflation and tighter monetary policy. However, due to
the precarious nature of the current recovery, if rates were to rise too
quickly, too soon, it could pose problems for the economy. Thus far, consumers
have benefited from low mortgage rates–which have come down in sympathy with
Treasury yields. Businesses have been able to borrow at much cheaper rates to
finance new projects, and they have been able to lower their existing debt
servicing costs–non financial borrowing costs as a percent of cash flow is now
at 22% vs. 26.4% in 2001. Equity valuations have also benefited from higher
present values of future cash-flows and earnings. Additionally, low yields have
weakened the US dollar–as investors have sought higher yielding assets
elsewhere– this, in turn, has helped boost profits for exporters (witness
the chart below for the close correlation between the US dollar and 10 year
yields)
As yields continue to rise, equity investors will increasingly place more
emphasis on corporate earnings to keep the stock market going up. So far
earnings projections continue to rise and are now up consecutively for the past
five months–as evidenced in the chart below. But at what level will a premature
rise in yields start to adversely affect the economy? My guess is that if
yields were to rise above the 4.5% – 4.75% level over the next couple of months,
the economy could begin to feel the strain.Â
Edward Allen