The Bear in the Room: The 10-year Treasury Rate
Where is the bottom for the stock market?
Technical experts have us looking for signs of a washout to establish a bottom for the stock market such as a low advance vs decline ratio, high put vs call ratios, extreme AAII bearishness, VIX at 35 or above, full fibonacci retracement, etc. The trouble is that past correlations do not establish causality. Often the stock market turns around from something fundamental before any of these conditions have been met. Today, most of these criteria have already been met, yet the market keeps going down. Listening to bottom-fishing advice often gives the impression that the experts want us to regress to Neanderthals walking around in loin cloths before the system is finally cleared of past speculative excesses.
Academia provides us with a better guide. Causality between Treasury rates and the stock market is bible in the Business Schools and is equally deserving in the real world. Increase the discount rate applied to future projected net cash flows and the net present value of a company declines. Decrease the rate and NPV goes up. Has anyone been watching the 10-year Treasury rate recently? The rise in this rate from 1.8% at year-end to close to 3% currently has mirrored the drop in the stock market.
Paul Tudor Jones shorted the market in 1987 when he saw that stocks had risen so much that the dividend yield had fallen to only 3% while risk-free Treasuries were still yielding 7%. The Treasury market had grown under the Reagan deficits, and large-scale trading between these two markets had become possible with the introduction of computers, he reasoned. Jones thought the deal was too good to pass up, so he shorted the market and made a fortune.
Fast forward to today. The stock market and the Treasury market are the two most liquid markets in the world. Daily arbitrage between stocks and Treasury bonds is instantaneous and efficient. Treasury bonds, particularly the 10-year, have become the de facto discount rate for the stock market. Academics will add an equity premium to bond rates to derive the discount rate, but there is no need to do that. Treasury bonds already include an equity premium because stocks that carry this premium are arbitraged with the bonds daily.
Because they are the de facto discount rate of the stock market, Treasury-bond rates have more of an impact on the market than the Federal Funds rate that analysts obsess over. The Federal Funds rate only affects the overnight rate that banks charge each other to lend excess funds. In today’s regime of excess bank reserves, an increase in the overnight rate has minimal impact other than to boost profits for banks sitting with these excess reserves in their vaults risk-free—about $1.9 trillion according to the Fed balance sheet. This policy has bolstered bank balance sheets since the financial crisis.
The limitations of the overnight Fed Funds rate became apparent in 2004-6. Greenspan, sensing the developing bubble in the housing market, raised the Federal Funds rate aggressively from 1% to 5% in an effort to head of excesses in the housing market, only to see the 10-year rate fall. The 30-year mortgage rate (often arbitraged with 10-year Treasuries) fell in tandem, adding fuel to the fire of the housing crisis. Frustrated by their lack of control over the most powerful interest rate, the Fed set out to rectify this weakness in the years following the Great Recession. They have succeeded beyond their wildest dreams. But be careful what you wish for.
The Fed since 2007 has accumulated $7 trillion worth of Treasuries on its balance sheet that span from 3-month issues to 30-year issues. Only recently did the Fed stop increasing the size of its balance sheet, i.e., put an end to QE (quantitative easing). But contrary to popular opinion, that is not the end of Fed largesse. Maintaining a balance sheet of this magnitude requires constant reinvestment of maturing issues to the tune of $100 billion per month.
At a time when most investors believe artificial pricing of Treasury bonds ended with QE, nothing of the sort has taken place yet. The Federal Reserve continues to be one of the largest purchasers of Treasuries simply to keep their balance sheet from shrinking. These purchases are an artificial boost to pricing, preventing free-market price discovery in the Treasury market. The Fed owns $300 billion worth or more than a third of all 10-year Treasuries outstanding compared with only 23% of Treasuries in general, showing that buying has been concentrated more on the 10-year.
In other words, today’s 3% interest rate on the 10-year Treasury is still being kept artificially low by the Federal Reserve, who keeps pushing prices up and therefore yields down. What would that rate be if the Fed backed off re-purchases entirely? The answer is not comforting.
According to Milton Friedman and the Taylor rule, interest rates will gravitate toward inflation plus a real rate of return of approximately 2%. Today’s inflation rate of 8% would therefore arguably result in a 10-year Treasury rate of 10% if the market were left to its own devices.
Applied to a Federal debt of $30 trillion, a 10% Treasury rate across the board would by itself add $3 trillion to the annual deficit. That would be an enormous drag on the US economy. It could put Congress into the predicament of having to raise taxes aggressively or face default. Neither is an option, and the Fed knows it.
The Fed must therefore keep re-purchasing Treasury bonds while inflation is high or watch rates soar. It is a race against the clock. Either inflation goes back down, allowing the Fed to keep reducing its balance sheet without spiking rates, or the rate on the 10-year goes to an unsustainable level, at which point the Fed will have to call it quits on QT and resume repurchases at 100% of cash that matures to push rates back down.
When does the Fed cry uncle on QT? Not any time soon if they stick to plan. At the last FOMC meeting, Jay Powell announced that QT will not even start until June 1, with a “cap” of $30 billion/month on the amount by which they reduce repurchases. That reduces re-purchases from $100 trillion per month to $70 trillion per month. That is a first step toward freeing Treasury issuance from government manipulation. This could begin to put upward pressure on the all-powerful 10-year rate, depending on the mix of Fed re-purchases. Assuming inflation is still high and exerting significant upward pressure on the 10-year rate next month, a $30 billion reduction in repurchases could easily drive the 10-year rate toward 4%. The stock market would react badly to this.
Then on September 1, the cutback on repurchases rises to $60 billion, according to the Fed. That cuts the Fed’s current firepower by more than half. If inflation has not fallen below 5% by then—and the chances are that it will not—then the upward pressure from inflation on the 10-year rate could drive it to 5%. And this is before the impact higher rates might have on slowing economic activity. The result could be painful for the market. An increase in the 10-year Treasury rate from 3% today to 5% by September could drive the S&P 500 down another 20%.
Note that there is nothing in the Fed playbook currently to avoid this scenario. They have received the 20% market decline so far with aplomb. Another 10-20% decline, however, might prompt them to change course. At that point, the Fed could save face by simply declaring the end of QT and going back tore-investing 100% of proceeds from maturities. The next 4-6 months may therefore not be a good environment for buying US equities no matter what the technical indicators say. There will be upward pressure on the all-important discount rate until inflation subsides.
Will inflation eventually subside? I suspect so. Events of the past two years have been extraordinary. Demand from Americans emancipated from Covid restrictions has ballooned while production of the goods and services they demanded fell behind, unusual for an economy that excels at escaping the laws of gravity. Eventually American innovation solves these problems. Our options this time, however, are limited. This time, because of the high Federal debt level, it’s low inflation or bust. Fifteen years of profligate spending, increasing the national debt from $8 trillion in 2008 to $30 trillion today, have come home to roost.
The 10-year Treasury rate is about to take flight. Watch it closely. Wait for inflation to fall or the Fed to call off QT before re-committing fully to the stock market.
Where could this approach be wrong?
1) Markets are forward looking. They are already pricing in higher rates. The question is, how much? The 10-year rate has historically been 5% with inflation running at 3-4%. This could be fully priced into the stock market already. Assuming inflation follows a trajectory toward 3-4% by next year, the market may take it in stride.
2) The 10-year Treasury bond is often purchased by investors fleeing for safety during bear markets. Ironically, the more a problem (including inflation) causes fear, the more investors looking for safety can drive rates down rather than up.
3) The economy may avoid a recession. Technology stocks continue to have strong demand independent of the stock market, unlike tech companies in 2000. Even if the economy is resilient, however, a strong economy can compete with the stock market for funds. A rising 10-year rate may cause more market distress even if there is no recession.
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