Stocks Are Cheap If Fed Controls the Yield Curve

Stock market cheerleaders are finally putting the never-ending rally in share prices into terms that bond investors can understand.

More and more, investors and analysts are justifying the records in the S&P 500 Index and the technology-focused Nasdaq 100 in the context of interest rates, which is ordinarily the domain of bond traders. Strategists at Bank of America Corp. attributed about 16% of the outperformance in technology stocks in recent years to falling bond yields; that’s a record high and more than twice the level observed before the 2008 financial crisis. The earnings yields on the S&P 500 and Nasdaq 100, which measure profit relative to share price, might be at the lowest levels since the early 2000s, but they’re still 296 basis points and 184 basis points more than the benchmark 10-year Treasury yield, respectively.

Even trailing 12-month dividend yields look compelling: 1.69% on the S&P 500 and 0.71% on the Nasdaq 100, compared with 0.65% for the 10-year Treasury note. And those rates aren’t skewed by a few companies: About 78% of individual stocks in the S&P 500 have a dividend yield that exceeds the 10-year U.S. yield, an all-time high and compared with an average of 25% in the past two decades, according to Russ Certo at Brean Capital.

All of this is to say: In many ways, it’s still possible to claim that stocks are cheap. But only if you believe the Federal Reserve will keep tight control over the yield curve.

Less than a month ago, on Aug. 6, the 10-year Treasury yield fell to as low as 0.5%. Three weeks later, the yield touched 0.79% — still low by any historical measure, but suddenly higher than the dividend yield on the Nasdaq 100 by the most since before the coronavirus pandemic took hold in America. The only other time this relationship reversed was in early June, when 10-year Treasury yields were heading toward 1%. After that, stocks swiftly sold off and yields fell back in line.

That past precedent was enough to make JPMorgan Chase & Co. strategists nervous. “With the long end of the curve already threatening a confluence of threshold signals for yields to break higher, continued price weakness has the potential to trigger another flow of momentum based selling pressure,” said Peng Cheng, a JPMorgan global quantitative and derivatives strategist. Bloomberg News’s Ven Ram wrote this week that “Treasury Yields Will Become a Headache for Stocks Around 1%.”

This time around, however, U.S. yields tumbled back into their range while the stock-market rally pushed forward unperturbed. What happened?

The Fed tipped its hand.

For evidence, look no further than the move in 10-year Treasuries on Tuesday, from a yield of 0.73% at 10:30 a.m. in New York to 0.67% by 3 p.m. There was no bad economic news; in fact, Institute for Supply Management data showed U.S. manufacturing expanded in August at the fastest pace since late 2018. It was hardly a risk-off day, either, with the S&P 500 advancing by 0.75% and a Bloomberg Barclays index of high-yield bonds gaining for the eighth consecutive session.