When 24/7 Wall St. ran its 10 serious risks that could wreck the raging bull market in stocks, a quick rise in interest rates was one of those risks. Now rates have started to rise at the onset of 2018 and what was the best start of the year since the 1980s for stocks suddenly has run into some pressure. Investors probably should not lose sleep over what has been seen so far in the rising interest rates, but they sure better not bury their head in the sand and ignore it.
There is a point that the yield on Treasury bonds will compete with stocks. That’s still a ways higher, but some serious consideration needs to be given to what is happening. It’s time to consider where Treasury yields are compared with dividends paid by corporations to common shareholders.
Whether you believe that China really will start backing away from Treasury notes and bonds is up to you. Frankly, that story seems trumped up and likely would be a negative for China, close to as much of a negative as it would be for the United States. One issue that will continue to pressure longer-term interest rates is the impact of tax reform on the corporate side of the economy — taxes dropping from 35% to 21%, immediate expensing and even the trickling down of higher wages and bonus checks.
The yield on the 10-year Treasury note rose approached 2.60% on Wednesday, and a 10-year Treasury auction just went off at a yield of 2.579%. That yield was just at 2.54% on Tuesday, and it was just at 2.40% as the close-out price for trading in 2017. As a reminder, the inverse correlation between bond prices and bond yields means that those yields rise as prices fall. That was a strong auction considering that rates just challenged a one-year high.
Higher inflation is another threat to interest rates, although inflation has yet to get out of hand. If tax reform is going to boost business massively, then continued price hikes and wage hikes could start to be more of an inflationary risk than what we have dealt with in recent years. The Treasury 30-year yield is now closer to 2.92%, still far short of that key 3% hurdle.
Out of the S&P 500 Index, 414 members pay dividends. Of those, the median dividend for the dividend payers is 1.96%. The median yield of all S&P 500 stocks, including the 0.0% yields, is 1.68%.
The median dividend yield on the Dow Jones Industrial Average is now 2.12%. The average yield was closer to 2.35%, if you simply take the mean of all 30 Dow stocks.
Most investors use the yield of the 10-year Treasury as the benchmark against equity yields. That being said, The S&P 500 was valued at roughly 19 times expected 2018 earnings. The 10-year Treasury’s yield of almost 2.6% is already some competition for equity investors, but now yields are up higher in the two-year and five-year Treasury notes too. The five-year yield is 2.34% (versus 2.21% at the end of 2017) and the two-year yield is now 1.97% (versus 1.89% at the end of 2017).
24/7 Wall St. recently released its forecasts for 2018 to its email distribution list. On interest rates, our message may sound simple enough on the surface:
Get ready for long-term interest rates to move higher. Not massively, but finally higher. The 10-year Treasury yield is likely to move back towards, but perhaps not much above, the 3.00% mark seen in 2013. We see at least two rate hikes by the Fed in 2018, but as of right now we are leaning toward 3 rate hikes.
The good news is that as strong as the economy has become, it is still rather fragile against any outside forces. If you wanted to make a rate hike extreme case of four or five rate hikes, in an effort to get back to normalization, too many more rate hikes could kill the appetite to buy stocks. If the 10-year yield gets up to 3.10% to 3.25%, that would probably compete handily for new investment funds against stock dividend yields.
Now that Jerome Powell is set to replace Janet Yellen as chair of the Federal Reserve, it is also expected that he will not want to raise interest rates endlessly. President Trump has been a fan of lower interest rates due to the economic advantages, and Powell’s appointment is deemed to be a status quo chair at this time. That could change, but that’s where it is now.
Another reason that investors might not need to overly worry about interest rates at this point is that there is an inherent conflict of interest. If the Fed raises interest rates too much then it is in effect forcing the government to pay more in its debt servicing costs rather than spend the money directly back into the economy. Take this into consideration with $20 trillion in debt: if the Fed were to drive up rates a theoretical 1% across the board, that would drive up the cost of debt financing by another $200 billion per year. That is a serious number, and it is not what any of the forecasters have been using for long-term debt accrual expectations.