Why Bond Yields are a Triple Sextuple Threat

10_year_ytd_20070612Last night, Larry asked me which was a bigger threat to stocks, a US/Iran conflict — or rising bond yields.

The correct answer was, of course, rising yields.   

I described it as a triple threat — but it may be even more than that; it could be a quadruple or quintuple or even sextuple threat!

Why? consider:

1) Valuation: Models such as the so-called Fed model that have been declaring equities undervalued rely on comparing the earnings yield with the 10 Year yield. As the yield spikes, what was "undervalued" by this measure suddenly is much less so.

2) The M&A / LBO Put:  One of the firm bids supporting this market has been the manic pace at which public companies have been taken private of by Private Equity (soon to be public themselves). Some have argued this was based on cheap stock prices, but we shall soon find out that it was based in fact on cheap money. As that gores away, so too will the LBO Put.

3) Competition:  If you could get a guaranteed 5.5% or 6% on your money — risk free — would you? The answer depends on your personal situation, but for many institutions and wealthy investors, the answer is absolutely.

4) Profits: If it costs more to borrow or finance, that bites into profits. Indeed, this has been one of the primary complaints about the Fed model, it double counts low rates this way, and can makes apparently cheap looking companies more expensive-looking in fast order as rates rise.

5) Share buybacks: Much of the share buybacks we have seen have been financed with cheap borrowed money. This is another leg of the bullish stool that is about to leave town on the same stagecoach as low rates. (cue music, sunset)

6) Consumer spending: WIth MEW sliding, we have seen an increase in consumer credit driven spending. Watch that crimp if rates stay near 5.25%. Indeed, we could see a move towards 5.5% by Summer’s end once people realize Bernanke is serious about a rate hike by year’s end.   

We have PPI and CPI out later this week, so this may all be moot by the weekend.

But with inflation over 3.4% in China, I somehow doubt that . . .

>

Sources:
Oh, Yeah — Inflation
David Gaffen
Maretbeat, June 12, 2007, 4:35 pm
http://blogs.wsj.com/marketbeat/2007/06/12/four-at-four-oh-yeah-inflation/

Chinese Inflation Fuels Few Worries So Far
By ANDREW BATSON
WSJ, June 13, 2007; Page A2
http://online.wsj.com/article/SB118162534329732351.html

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What's been said:

Discussions found on the web:
  1. Eclectic commented on Jun 13

    7)Threat of a Trip-Wire Event in Hedged Mortgage Portfolios.

  2. will rahal commented on Jun 13

    I commented yesterday on a chart that I have created, showing how for the first time in five decades, Personal Consumption of Non-durable Goods adjusted by wages, has risen to a new level,leaving less income available for discretionary spending.
    Guess why?
    Food and Energy INFLATION.
    See “Discretionary Spending and Income”

  3. REW commented on Jun 13

    All very valid, with the possible exception of #6. The death of consumer spending has been greatly exaggerated more times, and longer than I care to recount.

    ~~~

    BR You don’t consumers to die — just throttle back 10 or 15% — that would have a significant impact on overall GDP

  4. The Stalwart commented on Jun 13

    Why Stocks Wilt In The Face Of Rising Bond Yields

    Barry Ritholtz offers six reasons why. Here’s the first three:1) Valuation: Models such as the so-called Fed model that have been declaring equities undervalued rely on comparing the earnings yield with the 10 Year yield. As the yield spikes, what

  5. Jay Weinstein commented on Jun 13

    After being an orphan stepchild for the past 5 years or so, it appears the bond market is now getting its day in the sun as the stock market is now trading tick for tick with yields.

    I cannot imagine this is good for the bulls.

  6. david foster commented on Jun 13

    “If you could get a guaranteed 5.5% or 6% on your money — risk free — would you? The answer depends on your personal situation”…the answer should also depend on how much of the 5.5% or 66 represents real return vs inflation, since stocks offer at least some inflation protection whereas fixed-income securities offer none.

  7. Werner Merthens commented on Jun 13

    This is an excellent article. It is both timely and on point.
    I’d like to add that it is beneficial to look at stocks and bonds the way top management in corporations looks at potential acquisitions. A discounted cash-flow analysis is the centerpiece of their evaluation.
    In terms of stocks and bonds the equivalent is a cash-flow comparison between the two asset classes. For some reason this is known as the Fed model, although the Fed is not really in the picture here.
    I further believe that such a cash-flow comparison is both simpler and clearer than any conjecture about the shape of the yield curve.
    I have written about this subject here:
    http://musingsofaspeculator.blogspot.com/2007/06/about-yield-curves.html

  8. ManhattanGuy commented on Jun 13

    NEW YORK (AP) — U.S. stocks headed for a higher open Wednesday after retail sales showed the largest increase in 16 months, signaling higher gas prices might not be hitting consumers as hard as some on Wall Street had feared.

    The Commerce Department found that retail sales jumped 1.4 percent in May, which was double the increase analysts had been expecting. Retail sales fell by 0.1 percent in April.

  9. Jose Padilla commented on Jun 13

    Are bond yields going up because the Chinese have stopped buying our government debt?

  10. s0mebody commented on Jun 13

    It’s ridiculous that we exclude oil from the “core” CPI, yet we are so quick to count gas station sales in the retail numbers…

  11. Estragon commented on Jun 13

    eclectic – “7)Threat of a Trip-Wire Event in Hedged Mortgage Portfolios.”

    That may be the biggest threat of all, though I’d extend it to structured finance generally.

  12. Fred commented on Jun 13

    Barry…as there are two sides to a coin (and a trade), lemme shout out the obvious factoid that you’ve ignored.

    A positively sloped yield curve, with no inflation spread widening, screams that Goldilocks is making a sweet “touch and go” on the tarmack. GROWTH is back. Liquidity is showing NO SIGNS of receding, and will be seen in strong business loans, and banks finally making a spread. You also fail to mention, that credit spreads haven’t even stirred.

    As the Highway Patrol says to rubber neckers…move along…nothing to see here, folks.

  13. michaelmschumacher commented on Jun 13

    The two of you are made for each other

    Fred and Manhattan guy.

    Never have I seen or read such blissful ignorance as posted here today.

    From “Capex is STILL going to save us”
    to “look at the wonderful retail numbers that the Commerce Department puts out a day AFTER Greenspan tanks the market”

    Too funny…..are you two married??

    Ciao
    MS

  14. michaelmschumacher commented on Jun 13

    fred-

    I already have……

    total bullshit…..

    Ciao
    MS

  15. michaelmschumacher commented on Jun 13

    BTW when gasoline sales are able to be included in the retail numbers when it is most certainly NOT included in the inflation numbers sort of paints a skewed picture does’nt it?

    LOL

    Ciao
    MS

  16. GerryL commented on Jun 13

    The rise in interest rates will make the housing market even worse. It also will make all of the ARM resets worse. For some reason the effect on housing doesnt seem to be getting much attention.

  17. wunsacon commented on Jun 13

    MS, c’mon. Yes, I agree with your views and I know there’s a previous history here between you and some bulls. (I defended you at least once.) But, is there a need to scoff at Fred’s post this early in the day? (I don’t know how readers feel or whether you enjoy flaming each other. But, I prefer not seeing you guys go at each other.)

  18. Steve commented on Jun 13

    Those 4% GDP forecasts for Q2 are starting to look a little more plausible these days.

  19. capgme commented on Jun 13

    Bonds yields falling, equities rising. Bond yields are the current object of attention versus February and March when it was all about the Yen and carry trade. Lets see how long this bond yield/equities relationship holds.

  20. michaelmschumacher commented on Jun 13

    wunsacon

    touche’

    they absolutley call for it when they display such ignorance. But I agree with you it is a little early to have a ‘go.

    Ciao
    MS

  21. eugene linden commented on Jun 13

    I’d say it’s an octuple threat. Thirty-year fixed rate mortgages average a bit more than 1.5% above the 10 year. If they thus move towards 6.75%, that means that new mortgages will cost more than existing, further dampening refis and home sales, and tightening the noose on those facing resets.With a negative savings rate where does the consumer then turn to finance spending?

  22. Fred commented on Jun 13

    I have chosen to ignore MS, and his personal attacks, which speak for themselves.

    I do find it interesting that he is the only “respondent” to my counterpoints, the “intelligence” of those responses, notwithstanding.

    -positve slope
    -no inflation spread increase
    -no credit spread increase
    -90 day bill 89% of FFR = rate cut

  23. michaelmschumacher commented on Jun 13

    fred-

    if I attack you… you will know it…..

    If countering you’re totally ignorant posts with questions is attacking you then get thicker skin.

    Ciao
    MS

  24. The Old European commented on Jun 13

    Awareness of the deadlock in US rates policy: towards stagflation or towards hyper-inflation?
    – Announcement GEAB N°6 (June 16, 2006) –

    The financial and stock exchange players are now focusing on a single indicator, the evolution of the interest rates fixed by the central banks, and in particular that of the American Federal Reserve. Indeed, because of the United States central role in the world financial system, they play the part of the catalyst of hopes and fears; and their financial authorities will, during this phase II, accelerate the crisis. The US government and Federal Reserve have indeed led their economy and the whole of the financial markets towards a total dead end. The return of inflation has led to an increase in interest rates everywhere in the world, and the loss of confidence in the real American economy (with the background, the general loss of confidence in the United States) imposes a dramatic choice between two solutions with painful consequences:

    . Solution 1 – towards stagflation: to raise of the US interest rate to fight against inflation and to preserve the credibility of the Dollar (since it is only the differential in the interest rate with the EU and Japan that now maintains its relative value), but to accelerate the collapse of the growth of the United States economy, by making the real estate bubble (which is already deflating quickly) explode, and by disrupting up household consumption (on which the essence of the US growth has rested for 5 years). Inflation, high interest rates and growth at half-mast, even recession, this is a well-known situation which prevailed during the Seventies: stagflation [1].

    Awareness of the deadlock in US rates policy: towards stagflation or towards hyper-inflation?
    . Solution 2 – towards hyperinflation: stability of the US interest rates (and thus a drop of their relative value compared to the EU and Japan) to try (without guarantee, given the current state of the US economy [9]) to maintain the American internal growth and cause a collapse of the Dollar whose value “only just holds” on this differential, leading to the brutal interruption of the financing by the rest of the world of the American deficit (commercial and public) and thus a total financial crisis. This decision of course leaves the space open to inflation by trying to privilege growth, but it opens a period of generalized loss of confidence which reinforces, with the collapse of the Dollar, a very strong inflationary pressure in the United States which could lead to hyperinflation [10].

    LEAP/E2020 believes that the US Reserve Federal, whose shareholders are large banks [11], will choose Solution 1 because in the second case the Federal Reserve is itself marginalized and loses the possibility of using one of its main instruments of action (interest rates). In addition, the current president of the Federal Reserve is convinced that parallel to a rise of the interest rates, an additional contribution of liquidity [12] to the economy will make it possible for the latter to set out again on the path towards growth [13]

    For the team of LEAP/E2020, neither of the two solutions open to the American authorities can cure the total systemic crisis, their choice will be in fact primordial in determining the form and the extent of phase III of the total systemic crisis, the phase known as “impact phase”. The rest of the world will indeed not be affected the same way if the American authorities choose solution 1 or solution 2.

    http://www.leap2020.eu

  25. Philippe commented on Jun 13

    The US yield curve is FLAT and does not offer rewarding prospect for interest mismatch on long duration, either for the banks or financial institutions .
    As regards the confortable situation for the banks “The IMF as of June 5th has sent a stiff warning to the Swiss banking authorities asking them to put UBS and CS under closer scrutinity as any financial markets turmoil may represent a systemic risk for the Swiss banking system”

  26. BDG123 commented on Jun 13

    Everyone loves to point the finger at the American consumer and the US Fed as the blooming idiots. Indeed, they may be. But, European money supply growth has outstripped the US as has European credit growth. Hugely ditto in emerging markets and China. What will start the beginning of a boo boo is yet to be determined but with everyone squawking about the U.S. housing market and the dollar, I would assume it will be neither as those are simply too obvious. When the general public is squawking about both on every blog board known to man…….well…….. you get the picture.

    This leads me to an ancient Chinese proverb by Lao Tzu;

    Two men are confronted by a lion and one starts to put his tennis shoes on. The other looks in amazement and says, “You can’t outrun a lion.”. To which the other man says, “I don’t have to. I only have to outrun you.”.

    Moral of Lao Tzu’s proverb; The U.S. economy may be an ugly place right now. BUT, the rest of the world is much uglier and less dynamic environment with substantially less controls and hugely less risk management controls. Hence, less able to deal with future unknown shocks.

    If I were a betting man, I’d be betting that risk is being transferred right now from smart hands to stupid hands. Given the US and Europe have PhD’s in finance and the emerging world is full of clowns, who do you think the dumb money is?

  27. David Merkel commented on Jun 13

    Good post, Barry, but I would still call it a triple threat, because points 1, 2, 3, and 5 are variations on the same theme — comparing the value of equity to debt, and substituting debt for equity when it is economically advantageous to do so.

  28. Fred commented on Jun 13

    Old European…well, we’ll see.

    I do find it interesting that as our country is swinging mouthfoamingly to the left, your countries are embracing the “RIGHT”. Look forward to tax relief, and the dividends that they have brought here. Our economy was headed for the ditch, and all the predictions and armwaving of the recessions, dollar death spirals, consumer consitpation, etc, have all curiously been dead wrong.

    Good luck, and I’m happy for you.

  29. Fred commented on Jun 13

    Ah…The Beige Book. Growth with little inflation….Maufacturing and Capex pick up.

    I love the smell of napalm in the morning….it smells like…. Victory.

  30. The Old European commented on Jun 13

    Fred,
    That was just an excerpt of the “leap2020” website announcements, and only partially my opinion. They imply that the coming (or is it already here?) wave of inflation is going to “spare” the Euro. I think it is going to hit the euro almost as hard as the dollar, only with a certain delay due to the somewhat better outlook in terms of public deficit in the eurozone. Another thing that may help is the (too)slow replacement of the dollar by the euro in international financial transactions. But for now, I’d be watching the pound sterling. Anyone noticed the BOE’s inversed intrest rate curve?….

  31. Fred commented on Jun 13

    I personally expect tamer trading ranges in $$/Euro and both county’s bond yields. Europe has impressed me — very much, in fact.

    Good luck.

  32. ManhattanGuy commented on Jun 13

    Hey MS – Enjoy reading this news..

    Economy Heads Into Summer With Good Momentum, Helped by Manufacturing

    WASHINGTON (AP) — The economy headed into the summer with better momentum, propelled by a manufacturing rebound and consumers who eagerly went shopping and sightseeing despite high gas prices.
    This picture of the economy, released Wednesday by the Federal Reserve, seemed brighter in terms of prospects for overall economic growth. Factory production was up in a majority of districts, an improvement from the previous survey that found manufacturing was slow in most Fed districts.

    Consumer spending and retail sales across the country generally were up too, with luxury goods selling better than lower-end merchandise in some areas. Travel and tourism remained healthy but there was little change in auto sales.

    A separate report from the Commerce Department showed sales at the nation’s retailers in May posted their biggest gain in 16 months.

  33. ac commented on Jun 13

    Beware of Retail Sales. Noise is about all it is. Matter of fact, June is already looking like it will “balance” out May.

  34. ac commented on Jun 13

    Maufacturing and Capex pick up

    Not really. Basically inventory rebuilding in the HOPES it picks up. If it doesn’t, they will start dumping in July.

    July has been a huge month for sometime obviously.

  35. ac commented on Jun 13

    “Those 4% GDP forecasts for Q2 are starting to look a little more plausible these days”

    That inventory rebuild won’t show up in full to Q3 and PCE growth will be cut in half for Q2 2007.

    That business even attempted to rebuild(which I expected FWIW) inventory means no recession in Q3 2007 for sure.

    But the level of rebound that Quarter is going to depend on consumer strength. If they can’t hold up, business will completely slash the throat and shutdown for recession. If they can like treasuries are indicating, the expansion may have one more good year left in it (2008) before the downturn 2009-10 period, hey that has a 60’s feeling to it when growth rebounded after the 66-67 slump(06-07).

    This is what happened in 2000 after a they rebuilt inventory in Q3 2000. Quarterly growth rebounded in Q4 but consumption was weakening and the plug was pulled the following quarter. A yry growth recession started in the first quarter of 2001 and a aggregate recession started the next quarter yry.

    As I said before, July 2007 is a HUGE month. It will set the pattern for the next 18 months IMO.

  36. The Ponderings of Woodrow commented on Jun 13

    Ritholtz’ six reasons to worry about rising bond yields…

    Barry Ritholtz is one of my favorite market-focused bloggers; he has the rare ability to balance quantity and quality. This week, with the 10-year breaking the key psychological level of 5%, a lot of people are asking what that means

  37. zell commented on Jun 13

    Wunsacom; Owe you an answer from the other day – U.S./Iran conflict.
    Today the answer is rates. When it’s Iran/U.S. you will see limit down only. Check out today’s events in Gaza and Beirut.

  38. Greg0658 commented on Jun 14

    E=MC2
    Economic win = masses over time squared

    Rag tag fleet of pilgrims tame a new land, populate it, build infrastructure, become a war power with aspects from both sides of the coin, get brought to knees with war & trade debt throw in muddy economic law, endup with the new world transfering wealth to the old world.
    Taxed square world … goes round and round … Unity someday around currency.
    :-)

  39. The Big Picture commented on Jul 25

    Housing, LBOs

    Last month, I noted 6 reasons why rising yields were a threat to equity prices:ValuationThe MA/LBO PutCompetitionProfitsShare buybacksConsumer spendingAs of late, we have seen the threat of two of these issues increase dramatically: The MA/LBO Put and …

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