Jerome Powell’s Congressional testimony last week made the Fed’s position clear. Monetary policy will remain easy for the foreseeable future. Inflation dynamics change, but not on a dime. While Fed policy will leave short-term interest rates anchored near zero, the market’s inflation expectations have been rising. Last week, the 10-year Treasury yield briefly breached 1.6% and the 30-year Treasury yield rose as high as 2.4%.
Reflation, or inflation?
If interest rates are rising on the heels of reflation and real growth, that is positive for risk assets. In the last few decades, when interest rates have risen, it has been due to real growth. The markets have shown they are willing to tolerate the Federal Reserve’s suppression of interest rates in such a scenario.
But if interest rates are rising because of faster inflation, then that is not good for risk assets. All else being equal, inflation depresses real economic growth and earnings as purchasing power dwindles. During the inflationary period from 1966 to 1982, stocks lost 65% of their real (after-inflation) value as inflation raged. These real losses were not recouped until the mid-1990s. Inflation has not been a problem since the 1990s.
Here comes the YOLO recovery
Australia and New Zealand’s success in suppressing Covid-19 — outside isolated flare-ups — has sparked a snap-back in household and business sentiment, spurring activity and hiring and laying the ground for a sustained recovery. With vaccines being rolled out across the developed world, the prospect of a return to normal is tantalizingly within reach.
Households Down Under are cashed up due to government largess and limited spending options during their respective lockdowns. That prompted Aussies and Kiwis to salt away funds, freeing up room to consume.
“Substantial fiscal boosts, combined with an internalization of spending has driven a sharp rebound in spending by households in Australia and New Zealand,” said James McIntyre of Bloomberg Economics in Sydney. “Rising asset prices are delivering a further boost. But both economies could see recoveries whither as fiscal boosts fade and borders reopen.”
The Treasury’s decision — unveiled at its quarterly refunding announcement — will help unleash what Credit Suisse Group AG analyst Zoltan Pozsar calls a “tsunami” of reserves into the financial system and on to the Fed’s balance sheet. Combined with the Fed’s asset purchases, that could swell reserves to about $5 trillion by the end of June, from an already lofty $3.3 trillion now.
Here’s how it works: Treasury sends out checks drawn on its general account at the Fed, which operates like the government’s checking account. When recipients deposit the funds with their bank, the bank presents the check to the Fed, which debits the Treasury’s account and credits the bank’s Fed account, otherwise known as their reserve balance.
The flood of liquidity will have several effects. First, it could push short-term interest rates below zero, as Treasury has fewer needs to issue Treasury bills as it draws down its cash balance at the Fed. Watch for the Fed to announce that it will raise the rates it pays on excess reserves (IOER) to offset the downward pressure on short-term yields. If it does, don’t misinterpret this as tightening. It is only a technical change to the plumbing of the money market to prevent short-term rates from going negative.
The next question is what will happen to the billions as Treasury injects cash into the banking system. A rising tide lifts all boats, and undoubtedly some of the funds will find a home supporting consumer spending, and some will support stock prices. This development should be net equity bullish.
Here comes reflation.
Reflation is equity bullish
In the short-run, reflation is dominating the fundamental narrative. During the initial phase of an economic recovery, both earnings estimates and bond yields rise together. Equity prices rise because the bullish effects of rising earnings estimates overwhelm the bearish valuation effects of rising yields. Indeed, Ed Yardeni pointed out that forward S&P 500 revenues and sales are enjoying a V-shaped recovery.
When does the party end?
Moreover, stock market valuations aren’t overly stretched based on the equity risk premium even with higher Treasury yields, according to Goldman Sachs.
Investors ask whether the level of rates is becoming a threat to equity valuations. Our answer is an emphatic “no.” Although the S&P 500 forward P/E multiple of 22x currently ranks in the 99th historical percentile since 1976, ranking only behind the peak of the Tech Bubble in 2000, our dividend discount model (DDM) implies an equity risk premium (ERP) that ranks in the 28th percentile, 70 bp above the historical average. Similarly, even after the recent rise in yields, the 300 bp gap between the S&P 500 forward EPS yield of 4.6% and the 10-year US Treasury yield ranks in the 42nd historical percentile. Keeping the current P/E constant, the 10-year yield would have to reach 2.1% to bring the yield gap to the historical median of 250 bp. If instead the yield gap remains unchanged, and rates rise to 2.0%, then the P/E multiple would fall by 10% to 20x. But in today’s economic environment, our macro model suggests the ERP should be narrower than average.