Market Commentary

Fixed Income Conundrum

By Rob Sigler, MBA

January 8, 2025

A strange phenomenon has presented itself lately in the fixed income market.  Traditionally, when the Federal Reserve starts cutting rates, yields on virtually all maturities start to ratchet downward.  The blue line in the following Apollo illustration represents the average movement of the 10-year U.S. Treasury Bond yield during past easing cycles.  The green line, by contrast shows what has happened this cycle.  Rather than move lower, yields on longer dated maturities have raced higher.  What is causing this, and can it persist?  There appears to be a broad-based belief that U.S. economic growth is going to reaccelerate, inflation is going to stay persistently high, exacerbated by tariffs, and that the potential tax cuts and other fiscal stimulus measures planned by the Trump administration will continue to grow the Federal deficit.  The irony in this thinking, however, is that higher longer-term interest rates act as a major impediment to economic growth.  Home, automobile, and other large capital goods (furniture, appliances, electronics) purchases become much less affordable in high-interest rate environments.  Similarly, corporations rethink longer term capital projects as the investment hurdle rate climbs.  It is our belief that higher growth and higher for longer interest rates are inconsistent with one another and cannot coexist for long.  Something must give.

We argue that bonds look as attractive relative to stocks as they have in over 20 years.  How do we make that assertion?  One way to measure that relationship is to look at the earnings yield on stocks relative to yields on bonds.  An earnings yield simply calculates what would be the theoretical yield of a stock if it were to pay out 100% of its earnings in dividends.  The calculation is easily derived.  It is the inverse of the Price/Earnings ratio.  So, for the sake of illustration, the S&P 500 index collectively trades at a 22x P/E ratio.  If we divide 1/22, we arrive at the earnings yield = 4.55%.  The following Capital Group illustration allows us to see a time series of that relationship.  To wit, bonds yields have not equaled or exceeded the S&P 500 index earnings yield since late 2002.  We believe investors have largely given up on bonds with many embracing an acronym that we refer to as TINA (There Is No Alternative to stocks).  This has been supported by recent history, but a broader lens tells us that abandoning bonds at these levels is a short-sighted choice.

 

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