Now that Powell has convinced markets he means it

Before Bonds Were So Rudely Interrupted…

Jerome Powell seemed to get the message across this time. After the most recent Federal Open Market Committee meeting (last Wednesday, but it already feels much longer ago), bond yields fell as he laid out an extremely hawkish agenda in his press conference. The conventional wisdom is that traders took Powell's repeated insistence that the economy was strong enough to withstand repeated hikes as reason to be optimistic about the economy, rather than as a statement that he had no need to keep rates easy.

If there was any misunderstanding on that point, it's been cleared up. Once Powell's Monday lunchtime speech to the National Association for Business Economics went live on the Federal Reserve's website, bond yields surged upward into new territory. You can find the text of his prepared remarks here. It's fair to say that the whole thing is hawkish. The most important market-moving passage is this one:

In particular, if we conclude that it is appropriate to move more aggressively by raising the federal funds rate by more than 25 basis points at a meeting or meetings, we will do so. And if we determine that we need to tighten beyond common measures of neutral and into a more restrictive stance, we will do that as well.

One of the most intriguing points, I thought, was that the Fed chair went to some lengths to counter the strong narrative that the central bank cannot hike rates enough to thwart inflation without also engineering a recession. This chart shows three "soft landings" when hiking cycles did not result in recessions. The last was as long ago as 1994, a hiking cycle that caused a mess in Mexico and the rest of Latin America, and a lot has changed since then. But the point is well taken that the Fed can, on occasion, execute a significant tightening without prompting a recession:

In particular, if we conclude that it is appropriate to move more aggressively by raising the federal funds rate by more than 25 basis points at a meeting or meetings, we will do so. And if we determine that we need to tighten beyond common measures of neutral and into a more restrictive stance, we will do that as well.

One of the most intriguing points, I thought, was that the Fed chair went to some lengths to counter the strong narrative that the central bank cannot hike rates enough to thwart inflation without also engineering a recession. This chart shows three "soft landings" when hiking cycles did not result in recessions. The last was as long ago as 1994, a hiking cycle that caused a mess in Mexico and the rest of Latin America, and a lot has changed since then. But the point is well taken that the Fed can, on occasion, execute a significant tightening without prompting a recession:

Whether or not Powell showed any greater hawkish intent this week than last, he got his message across this time. This shows up most dramatically in the two-year Treasury yield, which in the course of this year has risen by 125 basis points. As marked on the chart, yields jolted upward with the publication of the December FOMC minutes, the January meeting, the strong January payrolls data, and then the awful consumer price index data for that month before Russia's invasion of Ukraine knocked yields sharply down. Last week's FOMC meeting, and now the Powell speech, have brought two-year yields right back on to a rising trend. A day that started amid speculation over whether the two-year yield could top 2% instead saw it exceed 2.1%: 

This in turn prompted one of the developments the Fed most dreaded. For two decades, inflation expectations have been "well-anchored," in the central banking argot. Bond market forecasts for the next five years stayed below 3%, and for the next 10 years below 2.75%. Those thresholds, marked below, have now been decisively breached. 

The importance of expectations in creating inflation is the subject of controversy, but this certainly gives the Fed a strong incentive not to desist. It looks as though inflationary psychology is getting out of hand, so it behooves the central bank to counter that.

Market-based expectations for how the Fed moves its target fed funds rate have also broken out. The shift in expectations has come with breathtaking swiftness. The following chart shows implicit expectations for rates after each of the next seven meetings as they stood on Dec. 31, where they had moved by the day the tanks entered Ukraine, and where they are now:

Powell Has Convinced the Market He Means It

Implicit expected interest rates have escalated since the end of 2021

Bear in mind that as the year began, CPI had already topped 7% for the first time in four decades. It's remarkable both how long it took for investors to come around to expecting a sharp monetary tightening, and how swiftly that realization has now taken root.

What does this imply for asset allocation? Higher bond yields tend to be bad news for stocks if they are part of a Fed tightening, and make high stock valuations harder to justify. However, expectations of a more aggressive Fed are even worse for bonds. The mathematics of the bond market on this point is inexorable. If rates and yields are going up, then bond prices have to come down.

And, indeed, just as those who've been saying There Is No Alternative (to stocks) would have predicted, this news has been far worse for bonds than stocks, meaning that the returns for those who are long in stocks relative to bonds have surged to yet another new high:

In October 2018, stocks reached a significant high relative to bonds. Investors simply didn't believe that the Fed would be able to tighten monetary conditions as it wanted, and forced a pivot from the central bank. That helped bonds to outperform for about 18 months leading in to the pandemic, when bonds fared radically better than stocks. But that has changed. Unlike 2018, so far at least, the prevailing market assumption seems to be that the Fed will go through with it this time. And that means stocks are notably outpacing bonds. Whether or not this is a time to "fill your boots," those who gave low bond yields as a compelling reason to buy stocks had a point.

How reasonable is it to expect this to continue? That can become a very esoteric question very quickly. Let me offer what my old math teacher used to call "brute force and ignorance" (always the best way to proceed if you didn't understand the question.) The following chart shows two versions of the simplest way to resolve the issue — take the earnings yield (inverse of the price/earnings ratio) on stocks, and subtract the 10-year bond yield, in either real or nominal terms. The higher this number, the better the argument for buying stocks rather than bonds. And on this crude basis, the spread over nominal yields gives no reason to switch out of shares, while the spread over real yields suggests this is still a good time to be buying into the stock market:

As we're in the unprecedented situation where real yields are negative while inflation surges toward double figures, this makes intuitive sense. Buying inflation protection through the bond market looks very, very expensive, so it stands to reason that stocks should provide a cheaper inflation hedge. 

There are lots of problems with using the current earnings yield, however. P/E ratios adjust if companies have just suffered unusually good or bad results, and also aim to take account of the earnings cycle; they will naturally be lower if earnings are expected to rise. To counter this, Yale University's Robert Shiller popularized the "cyclically adjusted P/E," or CAPE, which is the ratio of the current price to the real average of the previous 10 years' earnings. This is no use with timing, but has proved to be very helpful when trying to predict longer-term returns. 

In recent years, he has also encouraged the use of the "excess CAPE yield," which subtracts the 10-year bond yield from the CAPE of the S&P 500. This has proved to be a great predictor of the subsequent 10 years' returns — the higher the excess CAPE yield, the more we should expect average real returns on stocks to exceed real returns on bonds over the following decade. 

Shiller makes his calculations public, and you can find his regularly updated spreadsheet here. It hasn't been updated since the invasion, so in the following chart I input Monday's closing values for the S&P and the 10-year yield. Other elements in the calculation will also have changed a bit, so the number I produced won't be precise. But it's close enough. And the message is very clear: The ructions of the last few weeks have not changed the balance between stocks and bonds to any significant degree. It still looks a good bet that stocks will do better than bonds over the next decade:

Robert Shiller's Excess CAPE Yield Suggests Stocks Are A "Buy"

On long-term valuations, stocks still yield much more than bonds

For those interested in the comparison with the great historical parallel, the outbreak of the Yom Kippur War in 1973: As of the end of September that year, the ECY was 3.32%, very similar to its current level. The subsequent real excess return to be derived from stocks compared to bonds over the next decade was 2.76% — although be warned that this was a thanks to a negative annual return of 1.46% on bonds compared to a real 1.29% return on stocks. The exercise suggests that at times like this, it's probably better to hold stocks than bonds. If you have a bargepole, you should not touch any bonds with it. It doesn't suggest that this is an unusually good time to hold stocks.

John Authers is a senior editor for markets. Before Bloomberg, he spent 29 years with the Financial Times, where he was head of the Lex Column and chief markets commentator. He is the author of "The Fearful Rise of Markets" and other books.

Disclaimer: This article first appeared on Bloomberg, and is published by special syndication arrangement.