Surge in US bond yields: Will it spell end of fund flow rotation from bonds to equity?

Anubhav Sahu
Moneycontrol Research

The recent surge in the 10-year US treasury yield, which is now hovering around 3 percent, has raised concerns on the fate of risky asset classes. Talks of a possible de-rating in equity valuation premium, which was earlier fueled by liquidity and a low inflation environment, is gathering steam. The surge in bond yields, particularly the rate of change, has raised question mark on whether the ‘great rotation’ of flows from bonds to equity is going to stop or reverse.

Yield differential has drastically reduced
The wide gap in earnings yield, which is the inverse of price-to-earnings ratio, of the equity market and bond yield are often cited as a compelling case for equity investment from both an income and valuation perspective. The difference between the earnings yield of the S&P 500 index and US treasury yield has drastically reduced ever since US President Donald Trump assumed office. The S&P 500 has risen by about 27 percent since then and the 3.3 percent yield difference has reduced by almost half.

Source: Thomson reuters

Real interest rate not alarming given economic conditions
While nominal bond yields of three percent raise concerns, the real interest rate (adjusted for Consumer Price Index) is still hovering around a percent. The last time it was at this level was in early 2014 when economic conditions were still lagging the pre-crisis highs, the US Federal Reserve was fiercely debating starting the interest rate normalising cycle, the Eurozone was fighting deflation and a banking crisis, and emerging markets were weighed by weak commodities and subdued demand in global markets.

Normalised readings of bond yields are sanguine
Yield data (both earnings and treasury) normalised for long-term averages by taking the ratio of current value divided by long-term averages keeps the argument in favour of better earnings yield. The gap is not huge when compared to the later months of 2007 (before the financial crisis). However, one should bear in mind that in the earlier bouts of recession, economic conditions deteriorated 15-18 months before the crisis.

Source: Thomson reuters

If we look at data adjusted for prevailing inflation, the real yield gap is still huge at 1.6 percent, which means an about 15-20 percent increase in the S&P 500 could close the gap keeping everything else constant.

Source: Thomson reuters

Great rotation: Flow of funds
While fund flows to equity markets have been positive on the retail side, institutional buyers of US equities have not been a major participant. Instead there has been a sharp surge in buying for other equity markets. Having said that, equity fund flows are still lagging the exuberance shown in the preceding periods of 1999 and 2007 crisis.

Follow @anubhavsaysFor more research articles, visit our Moneycontrol Research page