Down Debt

Why Stock Investors Become “Squirrels” When Bond Yields Surpass 3%

Stock investors seem to be concerned when the 10-year Treasury yield trades above 3%. A look at corporate debt levels explains why, according to a closely-watched analyst.

“Neither the feds nor corporations can afford +10% Treasury yields, which was common in the 1970s. That’s why the ‘Fed Put’ is now about Treasury yields and why stock markets are overshooting 3%,” Nicholas Colas, co-founder of DataTrek Research, said in a Tuesday note.

Investors have been talking about a figurative Fed put since at least the October 1987 stock market crash that prompted the Alan Greenspan-led central bank to lower interest rates. A real put option is a financial derivative that gives its holder the right but not the obligation to sell the underlying asset at a defined level, called the strike price, serving as an insurance policy against a decline in the price. market.

A strong sell-off in Treasuries pushed yields higher, which move opposite to price, with the rate on the 10-year note TMUBMUSD10Y,
2.992%
rising above 3% on Monday for the first time since early May.

Stocks stumbled in 2022 as yields rose in response to high inflation and the Fed’s plans for aggressive rate hikes. The S&P 500 SPX,
-0.46%
last month flirted with bear market territory – a 20% pullback from a recent high – before rebounding, while the more rate-sensitive Nasdaq Composite COMP
-0.51%
crashed into a bear market earlier this year. The S&P 500 is down more than 13% since the start of the year, while the Dow Jones Industrial Average DJIA,
-0.53%
was down more than 9% and the Nasdaq lost 22.9%.

Colas noted that the US government’s public debt to gross domestic product is 125% today, down from 31% in 1979. Corporate debt is 49% of GDP from 35% in 1979, a-t -he declared (see graph below).

US non-financial corporate debt (bonds and loans) as a percentage of GDP.

Board of Governors, BEA, DataTrek Research

The corporate debt-to-GDP ratio is 40% higher than it was in the inflation and high interest rate environment of the 1970s, Colas said. This is offset by much higher equity valuations for public companies and large private companies than in the 1970s, he noted, observing that while issuing equity to pay down debt is not perhaps not the preferred choice of CEOs or shareholders, it can be done if debt service costs rise. uncontrollable.

But government and corporate debt now make up a much larger share of the U.S. economy than they did in the 1970s, which must figure into any discussion of inflation-fighting monetary policy measures, he said. declared.

The damage that could be done by the 10%+ Treasury and corporate returns of the 1970s would be much greater now, Colas said, arguing that’s why the “Fed put” moved from the stock market to the stock market. Treasure.

Fed Chairman Jerome Powell and his fellow policymakers “know they have to keep structural inflation at bay and Treasury yields low. Much, much lower than they were in the 1970s,” he said. declared.

According to Colas, this helps explain why US equity markets falter when Treasury yields hit 3%, as they have in the fourth quarter of 2018 and now.

“It’s not that a 3% cost of risk-free capital is inherently unmanageable, either for the federal government or the private sector. Rather, it is the market’s way of signaling the many uncertainties if rates do not stop at 3%, but continue to rise,” he said.