January 2019 Data Update 2: The Message from Bond Markets!

I must admit that I don't pay as much attention to fixed income markets, as I do to equity markets, other than to use numbers from the markets as inputs when I value companies or look at equity markets. This year, I decided to look at bond market movements, both in the sovereign bond and corporate bond markets for two reasons. First, bond markets offer predictive information about future economic growth and inflation, and since one of the big uncertainties for equities going into the new year is whether the economy could go into recession, it is worth paying attention to what bond investors are telling us. Second, one of the stories in the equity market during 2018 was that the price of risk, in the form of an equity risk premium, rose and became more volatile, and it makes sense to look at whether the price of risk in the bond market, taking the form of default spreads, also exhibited the same characteristics. Bear in mind, though, that the bond market is not my natural habitat and if you are a fixed income trader or an interest rate prognosticator or even a Fed Watcher, you may find my reasoning to be simplistic and perhaps even wrong.

The US Treasury Market

The place to start any assessment of interest rates is the US treasury market, with it range of offerings, both in terms of maturity (from 1 month to 30 year) and form (nominal and real). When valuing equities on an intrinsic value basis, it is the long term US treasury that is your opportunity cost (since your cash flows on equity are also long term in intrinsic value) and the ten-year US treasury bond rate is my input. (The 30-year US treasury may actually be better suited to equities, from a maturity perspective, but has less reliable history, more illiquid and subject to behaving in strange ways). The path of the US 10-year T. Bond on a daily basis is captured in the graph below:

At the start of the year, I had argued that there was a good chance that the 10-year T. Bond would hit 3.5% over the course of the year, but after reaching 3.24% on November 8, the rate dropped back in the last quarter, to end the year at 2.69%.  

Returns on T. Bonds and Historical Premiums

If you bought ten-year treasury bonds on January 1, 2018, the rise in the T.Bond rate translated into a price drop of 2.43%, effectively wiping out the coupon you would have earned and resulting in a return for the year of -0.02%. The consolation price is that you would have still done better than investing in US stocks over the year and generating a return of -4.23%. Updating the historical numbers for the United States, here is the updated score on what US stocks have earned, relative to T.Bonds and T.Bills over time:

Download historical annual returns

There is no denying that historically stocks have delivered higher returns that treasuries, but as we saw in the last quarter this year, it is compensation for the risk that you face. 

The Yield Curve Flattens

The big story over the course of the year was the flattening of the yield curve, with short term rates rising over the course of the year; the 3-month T.Bill rate rose from 1.44% on January 1, 2018 to 2.45%on December 31, 2018 and the 2-year US treasury bond rate rose from 1.92% on January 1, 2018 to 2.42% on December 31, 2018. The yield curve flattening is shown in the graph below:

By December, a portion of the yield curve inverted, with 5-year rates dropping below 2-year and 3-year rates, leading to a flood of stories about inverted yield curves predicting recessions. I did post on this question a few weeks ago, and while I will not rehash my arguments, I noted that the slope of the yield curve and economic growth are only loosely connected.

The TIPs Rate and Inflation

Finally, I  looked at the rate on the inflation protected 10-year US treasury bond over the course of the year, in relation to the US 10-year bond. 

Note that the difference between these 10-year T.Bond rate and the 10-year TIPs rate is a market measure of expected inflation over the next ten years. Over the course of 2018, the "expected inflation" rate has stayed within a fairly tight bound, ranging from a low of 1.70% to a high of 2.18%. In fact, if the return on inflation was on investor minds, the memo seems to have not reached this part of the bond market, with expected inflation decreasing over the course of the year.

What now?

At the start of last year, when investors were expecting much stronger growth in the economy and had just seen a drop in corporate tax rates, the debate was about how much the US treasury bond rate would climb over the course of 2018. As we saw in the section above, the 10-year US treasury bond rate did rise, but only moderately so, perhaps because there was a dampening of optimism about future growth in the last quarter. That said, the Federal Reserve and its chair, Jerome Powell, are still the focus of attention for some investors, obsessed with what the central bank will or will not do next year.  

Intrinsic Riskfree Rates

As some of you have read this blog know well, I am skeptical about how much power the Fed has to move interest rates, especially at the long end of the spectrum, and the economy. To get perspective on the level and direction of long term interest rates, I find it more useful to construct what I call an intrinsic risk free rate by adding together the inflation rate and real GDP growth rate each year. The figure below provides the long term comparison of the actual treasury bond rate and the intrinsic version of it:

Download raw data

There are two versions of the intrinsic risk free rate that I report, one using just the current year;'s inflation and real growth and one using a ten-year average of inflation and real GDP growth, which I will termed the smoothed intrinsic risk free rate. This graph explains the main reasons why interest rates dropped after 2008, very low inflation and anemic growth. As growth and inflation have picked up in the last two years, the treasury bond rate has stayed stubbornly low, and for those who blame the Fed for almost everything that happens, this was a period during which the Fed was raising the Fed Funds rate, the only interest rate it directly controls, and scaling back on quantitative easing. At the end of 2018, the treasury bond rate (2.68%) lagged the contemporaneous intrinsic risk free rate (5.54%) by 2.86% and the smoothed rate (3.58%) by 0.90%.

Reading the Tea Leaves

What does this all mean? I am no bond market soothsayer, but I see two possible explanations. One is that the bond market is right and that expected growth in the next few years will drop dramatically. The other is that bond market investors are being much too pessimistic about future growth, and that rates will rise as the realization hits them.  I believe that the truth falls in the middle. Nominal growth in the US economy will drop off from its 2018 levels, but not to the levels imputed by the bond market today, and treasury bond rates will rise to reflect that reality. In the absence of a crystal ball, I will hazard a guess that the US 10-year treasury bond rate will rise to 3.5%, the smoothed out intrinsic rate, by the end of the year, and that GDP growth will drop by a percent (in nominal and real terms) from 2018 levels. As with all my macroeconomics predictions, this comes with a  money back guarantee, which explains why I do this for free.

The US Corporate Bond Market

If the government bond rate offers signals about future inflation and expected growth in the economy, the corporate bond market sends its own messages about the economy, and specifically about risk and its price. In particular, the spread between a US $ corporate bond and the US Treasury bond of equivalent maturity is the price of risk in the bond market. To see how this measure moved over the course of the year, I looked at the yields on a Aaa. Baa and Can 10-year corporate bonds (Moody's) relative to the US 10-year treasury  bond over the course of the year:

As with the equity risk premium, default spreads widened over the course of the year for all bond ratings classes, but more so for the lower ratings. Also, similar to the pattern in equity markets, all of the widening in the equity risk premium happened in the last quarter of 2018. In fact, the intraday volatility of default spreads increased in October, mirroring what was happening in the equity market. In a later update, I will be looking at country risk, using sovereign default spreads as one measure of that risk. These default spreads also widened in 2018, setting the stage for higher country risk premiums. All in all, 2018 saw the price of risk go up in both the equity and debt markets, and not surprisingly, companies will see higher costs of capital as a consequence.

Bottom Line

For the most part, the bond and stock markets were singing from the same song book this year. Both markets started the year, expecting continued strength in the economy, but both became less upbeat about economic prospects towards the end of the year. For stock markets, this translated into expectations of lower earnings growth and stock prices, and for bond markets, its showed up as lower treasury bond rates and higher default spreads. Investors in both markets became more wary about risk and demanded higher prices for taking risk, with higher equity risk premiums in the stock market and higher default spreads in the bond market. 

YouTube Video

Datasets

1. Historical Returns on Stocks, T. Bonds and T.Bills - 1928 to 2018
2. T. Bond Rates, Inflation and Real Growth - 1953 to 2018
3. Corporate Bond Default Spreads - Start of 2019

January 2019 Data Updates

1. Data Update 1: A Reminder that equities are risky, in case you forgot!
2. Data Update 2: The Message from Bond Markets
3. Data Update 3: Playing the Numbers Game
4. Data Update 4: The Many Faces of Risk
5. Data Update 5: Of Hurdle Rates and Funding Costs!
6. Data Update 6: Profitability and Value Creation!
7. Data Update 7: Debt, neither poison nor nectar!
8. Data Update 8: Dividends and Buybacks - Fact and Fiction!
9. Data Update 9: Playing the Pricing Game!

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The Fed, Interest Rates and Stock Prices: Fighting the Fear Factor

If it feels like you are reading last year’s business stories in today's paper, there is a simple reason. The Federal Reserve's Open Markets Committee (FOMC) meeting date is approaching, and in a replay of what we have seen ahead of previous meetings, we are being told that this is the one where the Fed will lower the boom on stock markets, by raising interest rates. While this navel gazing may keep market oracles, Fed watchers and CNBC pundits occupied, I think that the Fed’s role in setting interest rates is vastly overstated, and that this fiction is maintained because it is convenient both for the Fed and for the rest of us. I think that there are multiple myths about the Fed’s powers that have taken hold of our collective consciousness, and led us into an investing netherworld. So at the risk of provoking the wrath of Fed watchers everywhere, and repeating what I have said in earlier posts, here are my top four myths about central banks.

1. The Fed sets interest rates

Myth: The Federal Reserve (or the Central Bank of whichever country you are in) sets interest rates, short term as well as long term. In my last post on this topic, I mentioned my tour of the Federal Reserve Building, with my wife and children, and how sorely tempted I was to ask the tour guide whether I could see the interest rate room, the one where Janet Yellen sits, with levers that she can move up or down to change our mortgage rates, the rate at which companies borrow from banks and the market and the rates on US treasuries. 

Reality: There is only one rate that the Federal Reserve sets, and it is the Fed Funds rate. It is the rate at which banks trade funds, that they hold at the Federal Reserve, with each other. Needless to say, not only is this an overnight rate, but it is of little relevance to most of us who don't have access to the Fed windows. While there is a tenuous link of Fed Funds rate to short term market interest rates,  that link becomes much weaker when we look at long term rates and their derivatives.

Why preserve the myth: Giving the Fed the power to set interest rates gives us all a false sense of control over our economic destinies. Thus, if rates are high, we assume that the Fed can lower them by edict and if rates are too low, it can raise it by dictate. If only..

2. Low interest rates are the Fed’s doing

Myth: Interest rates are at historic lows not just in the United States but in much of the developed world, and it is central banking policy that has kept them there, through a policy of quantitative easing The myth acquires additional sheen when accompanied by acronyms such as QE1 and QE2, which bring ocean liners to my mind and a nagging fear that the next Fed move will be titled the Titanic!

Reality: The Fed has had a bond-buying program that is unprecedented and large, but only relative to the Fed's own history. Relative to the size of the US treasury bond market (about $500 billion a day in 2014), the Fed bond-buying (about $60-$85 billion a month) is modest and unlikely to have the influence on interest rates that is attributed to it. So, what has kept rates low? At the risk of rehashing a graph that I have used multiple times, it is far simpler and more fundamental, and it lies in the Fisher equation, which decomposes the nominal interest rate into its expected inflation and real interest rate components:

Nominal Interest Rate = Expected Inflation + Expected Real Interest Rate

If you make the assumption that in the long term, the real interest rate in an economy converges on real growth rate, you have an equation for what I call an intrinsic risk free rate.  In the graph below, I graph out the actual US 10-year treasury bond rate against this intrinsic risk free rate and you can make your own judgment on why rates have been low for the last five years.'

To me, the answer seems self evident. Interest rates in the US (and Europe) have been low because inflation has been non-existent and real growth has been anemic, and it is my guess that rates would have been low, with or without the Fed’s exertions. In fact, the cumulative effect of the Fed's exertions can be measured as the difference between the intrinsic risk free rate and the US treasury bond rate, and during the entire quantitative easing period of 2008-2014, it amounted to about 0.13%. It is true that the jump in US GDP in the most recent quarter  has widened the difference between the treasury bond rate and the intrinsic interest rate, but it remains to be seen whether this increase is a precursor to more healthy growth in the future, or just an one-quarter aberration. 

Why preserve the myth: I think it is much more comforting for developed market investors to think of low interest rates as an unmitigated good, pushing up stock and bond prices, rather than as a depressing signal of future growth and low inflation (perhaps even deflation) in much of the developed world. That problem will not be fixed by Fed meetings and is symptomatic of shifts in global economic power and a re-apportioning of the world economic pie.

3. The reason stock prices are so high is because rates are low

Myth: Stock prices are high today because interest rates are at historic lows. If interest rates revert back to normal levels, stock prices will collapse. 

Reality: Low interest rates have been a mixed blessing for stocks. The low rates, by themselves, make stocks more attractive relative to the alternative of investing in bonds. But if the low rates are symptomatic of low inflation and low real growth, they do have effects on the cash flows that can partially or completely offset the effect of low rates. One way to decompose the effects is to compute forward-looking expected returns on stocks, given stock prices today and expected cash flows from dividends and buybacks in the future to see how much of the stock price effect is fueled by interest rates and how much by cash flow changes. If this bull market has been entirely or mostly driven by the drop in interest rates, the expected return on stocks should have declined in line with the drop in interest rates. In my most recent update on this number at close of trading on August 31, 2015, I estimated an expected return of 8.50%, almost unchanged from the level in 2009 and higher than the expected return in 2007. 

At least based on my estimates, the primary driver of stock prices has been the extraordinary fountain of cash that companies have been able to return in the last few years, combined with a capacity to grow earnings over the same period. By the same token, if you are concerned about cash flows, it should be with the sustainability of these cash flows, for two reasons. The first is that earnings will be under pressure, given the strength of the dollar and the weakness in China, and this is starting to show up already, with 2015 earnings about 5-10% below 2014 levels.  The second is that companies will not be able to keep returning as much as they are in cash flows; in 2015, the cash returned to stockholders stood at 91% of earnings, a number well above historic norms. In the table below, I check to see how much the index, which was at 1951.13 at the close of trading on September 3, would be affected by an increase in interest rates (increasing the US 10-year T.Bond rate from the 2.27% on September 3, to 5%) as contrasted with a drop in cash flows (with a maximum drop of 25%, coming from a combination of earnings decline and reduced cash payout):

Base: S&P 500 on September 3= 1951.13, T.Bond rate = 2.27%; ERP = 6.34%, g=6.30%

If you hold cash flows constant, an increase in interest rates has a relatively small effect on stock prices, with stock prices dropping 8.76%, even if the US T.Bond rate rises to 5%.  In contrast, if cash flows drop, the index drops proportionately, even if interest rates remain unchanged. You are welcome to make your own "bad news" assumptions and check out the effect on value in this spreadsheet.

Why preserve the myth: For perpetual bears, wrong time and again in the last five years about stocks, the Fed (and low interest rates) have become a convenient bogeyman for why their market bets have gone wrong. If only the Fed had behaved sensibly and if only interest rates were at normal levels (though normal is theirs to define), they bemoan, their market timing forecasts would have been vindicated. 

4. The biggest danger to the Fed is that the market will react violently to a change in its interest rate policy

Myth: The biggest danger to the Fed is that, if it reverses its policy of zero interest rates and stops its bond buying, stock and bond markets will drop dramatically.

Reality: While no central bank wants to be blamed for a market meltdown, the bigger danger, in my view, is that the Fed does what it has been promising to for so long, and nothing happens. That is a good thing, you might say, and while I agree with you in the short term, the long-term consequences for Fed credibility are damaging and here is why. The best analogy that I can offer for the Fed and its role on interest rates is the story of Chanticleer, a rooster that is the strutting master of the barnyard that he lives in, revered by the other farm animals because he is the one who causes the sun to rise every morning with his crowing (or so they think). In the story, Chanticleer’s hubris leads him to abandon his post one morning, and when the sun comes up anyway, the rooster loses his exalted standing. Given the build up we have had over the last few years to the momentous decision to change interest rate policy, think of how much our perceptions of Fed power will change, if stock and bond markets respond with yawns to an interest rate policy shift.

Why we hold on to the myth: If you buy into the first three myths, this one follows. After all, if you believe that the Fed sets interest rates, that it has deliberately kept interest rates low for the last five years and that stock prices are high because interest rates are low, you should fear a change in that policy. Coupled with China, you have the excuses for your underperformance this year, thus absolving yourself of all responsibility for your choices. How convenient?

What next?
Over the last five years, we have developed an unhealthy obsession with the Federal Reserve, in particular, and central banks, in general, and I think that there is plenty of blame to go around. Investors have abdicated their responsibilities for assessing growth, cash flows and value, and taken to watching the Fed and wondering what it is going to do next, as if that were the primary driver of stock prices. The Fed has happily accepted the role of market puppet master, with Federal Bank governors seeking celebrity status, and piping up about inflation, the level of stock prices and interest rate policy. Market watchers, journalists and economists have found stories about the Fed to be great fillers that they can use to fill financial TV shows, newspaper and opinion columns.

I don't know what will happen at the FOMC meeting, but I hope that it announces an end to it's "interest rate magic show". I think that there is enough pent up fear in markets that the initial reaction will be negative, but I am hoping that investors move on to healthier, and more real, concerns about economic growth and earnings sustainability. If the Fed does make its move, the best news will be that we will not have to go through more rounds of obsessive Fed watching, second-guessing and punditry.

YouTube Video

1. The Fed did it!
2. Slides to accompany video

Past Posts

1. The Fed and Interest Rates: Lessons from Oz (June 21, 2013)
2. Dealing with Low Interest Rates: Investing and Corporate Finance Lessons (April 2015)

Data

1. Interest Rates, Stock Prices and Expected Returns

Spreadsheets

1. S&P 500 Intrinsic Value Calculator

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