Why You Should Keep A Close Eye On These Two Indicators
The rout in US
Treasuries continues and yields keep moving up as a result.
Typically, a sell-off in government bonds isn’t a source of concern for equity
market participants, since the move in Treasury prices occurs in reaction to a
stronger economy. This time however, due to the fact that the move in Treasuries
is occuring during the early phase of an economic recovery, some market observers
(including the writer of this column) have expressed concern that a sustained
and pronounced sell-off could have negative consequences for the equity markets.
Why?
Rising yields directly affect equity valuations.
To be specific, interest rates are used in stock valuations to discount future
earnings and cash flows. Until recently, falling interest rates had been pushing
equity valuations higher due to the rising present values of future earnings and
cash flows. However, the recent sell-off in government bonds has been pushing
yields (which are inversely related to price) higher, and the burden of pushing
valuations higher is increasingly shifting on earnings.
So far, earnings have been rising, and,
therefore, preventing equity valuations from becoming stretched. Third quarter
earnings estimates have been improving significantly. Upward revisions as a
percent of total monthly revisions is now close to 60%, and forward earnings
have risen sequentially in the double digits for the last three months.
Credit spreads, which measure the difference
between corporate bonds and–almost risk free–Treasuries, continue to narrowÂ
This is also important as it is telling us that the bond market believes that
the economic recovery and corporate profits will continue to improve–as can be
evidenced in the chart below. Â
In sum, concurrent indicators, such as forward
earnings and credit spreads, are not yet showing any worrisome signs for equity
investors. Nevertheless, investors should keep a close eye on these two
indicators in the weeks ahead for any new developments.
 ‘
Witness the recent rise in 10 year Treasury note yields.