For intermediate term pain, a yield on the 10-year of around 4% has a better than even money chance of causing a 20% decline in stocks. Longer term: still a bull market for 6 - 12 months.
Dammit. I forgot the first two rules they teach you in junior prognosticator school:
Rule #1: Waffle. Hem-and-haw, use lots of "on the other hand's".
Rule #2: If you give a price target do not give a time frame. Be vague, wave your hands to distract...
As I head back to the remedial class, here's Bond Economics (also on blogroll at right):
The bear market in Treasurys is ongoing, which I do not view as particularly surprising. The usual way to generate excitement about the bond market is to claim that there will be horrific consequences if some technical level on the 10-year benchmark (or sometimes the 30-year benchmark) is reached. Although attention-seeking behaviour would probably get me more page views, I call them the way I see them. There is absolutely no reason for equity investors to care about what is happening in the Treasury market right now, and it would take something really big for that to change.
(To give a disclaimer that my regular readers will have seen many times, I do not give investment advice to random strangers on the internet. There is a "safe harbour" in economic commentary to allow the general discussion of interest rates as part of economic discussion, but I stay away from providing yield forecasts to avoid turning into a stopped clock repeating the same view. I am a recovering secular bond bull, but even we recognise that there will be cyclical bear markets that will punctuate the ongoing bull trend. Given that we are in a rate hike cycle, it is conventional wisdom that there should be some associated bear market.)
Bear Blues
I am in the final stages of producing a handbook on breakeven inflation analysis, and so I am not paying a great deal of attention to the day-to-day movements in bond yields. It is clear that the changes in personnel at the Fed has coincided with the beginning of an uptrend of bond yields. For those of us who are not deeply in love with New Keynesian economics, this is not surprising. Once we drop the largely unfalsifiable belief that the economy reacts violently to small changes in the expected path of the short rate, we see that the policy rate setting is to a certain extent discretionary. That is, we could have roughly the same economic outcome if the policy rate had been hiked at a less gradual pace over the past years. (There are some obvious disclaimers; a 75 basis point rate hike in a single meeting would legitimately cause a market freak out. The 1994 bond bear market coincided with a rate hike cycle that featured 75 basis point hikes.) This means that personnel changes at the Fed matter more for the rate outlook than many models would suggest....MUCH MORE
If we look at the big picture, the 10-year Treasury is still moving towards the top end of a multi-year trading range, and still well below the 2010 peaks. I normally would not want to catch the falling knife of bond prices in the middle of a rate hike cycle unless I had reasons to believe that a recession is imminent, but at the same time, the pace of rate hikes is so glacial that it is hard to get excited about the bear case. Needless to say, I am glad that I am not providing bond yield forecasts at this juncture, and if I were being paid to do so, I would mainly be building recession probability indicators.
Should anyone care about rising yields? I see no reason to do so, although I would note that I am not current with developments in U.S. real estate; if weakness develops there, interest rates will matter. However, I would argue that the reasonable strength of the labour market (discussed below) should trump interest rate effects for the housing market for a long time.
In interests of space, I will only discuss the interaction of higher Treasury yields and equities; perhaps emerging markets are sensitive to higher Treasury yields, but I am definitely not the person to get views on that subject.
From the perspective of an asset allocation, high grade bonds provide a laughably low guaranteed yield. If one is liability matching (as discussed recently), these low returns might be acceptable if we are immunising liabilities with a low hurdle rate. However, a significant portion of price determination is being done with an eye on long-term returns, and low Treasury yields are not even close to target return levels. If the rise in yields is the result of optimism about the economy, there is no need to allocate towards Treasury bonds to act as a portfolio hedge (which is the main justification for owning the things on a non-levered basis).
Will rising yields matter for equity valuation? For workhorse infinite horizon dividend discount (or earnings discount) models, what matters is the discount rate less the growth rate of dividends (earnings). Unless we are pessimistic about incumbent management teams at the S&P 500 companies (and as a disclaimer, I am), earnings/dividends should at least keep up with the nominal growth rate of the economy. (As equity bugs will jump to point out, a significant portion of S&P 500 earnings comes from overseas. I am not the person to discuss that complication.)...
