SPY vs. TLT

2013 is beginning the year with a strong dichotomy in asset class returns.  While the S&P 500 is on pace to have its best January since 1997, the 10 year yield has moved higher by 20 bps.  Expressed in more intuitive terms, SPY is up 5.3% year to date, while TLT is down 3%.  The divergence between the two could represent some psychological pain for any investors substantially invested in bonds.

How Long Can Real Interest Rates Remain Negative?

Ray Dalio made some news this week when he acknowledged that interest rates had probably gone about as low as they could possibly go and that the next big opportunity will be shorting the bond market.  I'm inclined to agree, but there is some historical precedent for rates to go lower and stay there for even longer.

Dalio argued that real rates are currently negative (nominal rate minus inflation)--which they are--but they were also negative for 10 years between 1936 and 1946 as shown by the chart below, which compares Moody's average Aaa bond yield to the realized 10 year forward inflation rate.  Inflation was high during this period, reaching above 10% in some years thanks to WWII.  The fact that rates stayed low is a testament to the fact that it's not a good decision to try to fight the Fed.

Used Aaa bonds as proxy for risk free rate.  Source: Federal Reserve Data

Long Term Historical Correlation of S&P 500 with Interest Rates

In the previous post I highlighted how the correlation of rates and the S&P 500 has turned slightly negative, which is an infrequent occurrence judged over the last 10 years.  The risk on/risk off trade has thrived on the idea that rates and stocks are positively correlated (i.e. when stocks go down bonds rally (rates fall) and when stocks go up bonds sell off).  This is likely a function of the fact that the risk premium (as opposed to inflation expectations) is the primary driver of price fluctuation in the current environment.

For most of the 20th century, risk premium was less important than inflation premium though, which led to an inverse correlation of rates and equities.  Because inflation was a greater component of a company's cost of equity, as inflation expectations fell, interest rates fell (as did the cost of equity) and stocks rallied along with bonds.  If inflation ever becomes a dominant theme again, then one might expect the correlation that has been the heart of the risk on/risk off trade to get turned on its head.  What happens to the algo guys if that happens?

Correlation of Rates and S&P 500

Operation twist has had the opposite effect on rates that outright QE has had, but equities have rallied during twist just like they did during QE1/2.  This has lead to a divergence between equities and interest rates over the past year.  Previously equities and rates had been relatively correlated: when equities moved higher so did interest rates.  Recently though, the daily correlation has broken down and over the past year has actually turned slightly negative.

QE Effect on Interest Rates

Consensus seems to be growing that the Fed is definitely going to announce some sort of new QE today.  From an academic standpoint QE is supposed to lower interest rates in order to spur lending and economic activity, but as a reminder the last two times that there have been unsterilized printing programs rates have actually risen because QE has created the appearance of inflation.  Only operation twist, a sterilized maturity swap program has been effective at flattening the yield curve.  Below is a chart of the 10 year yield with QE dates highlighted.

TLT Nearing S&P 500 Drawdown

Are bonds always less risky than equities?  If TLT's recent move teaches investors anything the answer should be an emphatic no.  Earlier this year the S&P 500 saw a drawdown (top to bottom loss) of ~10%.  Over the last month TLT, an ETF matching the return of long term US treasuries, has lost nearly the same amount as interest rates have risen.  The moral of the story:  holding duration on the long end of the curve can create equity like returns and equity like volatility.

How Much Have Companies Benefited From Lower Interest Expense?

In an attempt to quantify the extent to which lower interest rates have helped corporate America, below is a chart of the total interest expense of S&P 500 companies for the last 10 years.  On an aggregate level, interest expense is below where it was in 2005, and as a percent of EBIT it is the lowest it has been in 10 years.  The lower interest costs are a result of both lower rates and deleveraging.  Total debt of S&P 500 companies is down from $7.4T to $6.7T since 2010.

Lower interest expense has added $157B in earnings before tax to S&P 500 companies.  If you assume a 35% tax rate and a market multiple of 14x earnings, the lower interest expense has added approximately $1.4T in market cap to the S&P 500--about 10% of the total market cap of $13.2T.

TLT Down by 5.5% Since July 25

For those who still like to think of US Treasury bonds as risk free, below is a reminder that duration on the long end of the curve can lead to equity like returns both on the up-side and the down-side.  TLT, the long bond ETF is down 5.5% since 15 days ago.  It's still up 2.5% ytd (excluding dividends), but the 30 year bond has only moved from a ~2.5% to  ~2.8% yield.

Japan Short Term Long Term Bond Spread

Earlier today I posted a chart of the flattening US yield curve.  I thought for reference it might be interesting to look at Japan's yield curve over the last few decades.  The curve hasn't ever quite inverted, but has gotten to a 0.5% spread on a few occasions.

It's important to note that it's not clear what the maturity of the short term bond is from the data source that I pulled this from, so this isn't necessarily an apples to apples comparison to the US chart.  It looks to me like the short term chart may be more equivalent to a fed funds rate than a 2 yr bond.  It's an interesting chart in its own right and is posted below.

Japan has been in ZIRP for over a decade.  There remains no empirical evidence that ZIRP is effective in stimulating economic growth.