By
John Overstreet
:
In the beginning, commodity prices and yields were one.
Or at least as far back as 1730 and up until the 1910s, consumer
and producer prices were highly correlated with equity and bond
yields. That is to
say
, it was not the rate of inflation that was correlated with yields
but the absolute level of prices that moved with yields.
When one considers the tremendous technological, ideological,
demographic, scientific, and geopolitical changes that occurred
over those centuries in contrast with the stability of this
relationship, this suggests that we are confronted with something
like a natural law of markets and economics. And, yet laws were
made to be broken, it seems.
(click to enlarge)
(Note: All data in this article comes from Robert
Shiller
, except corporate bond data in the chart above, which is from
the St Louis
Fed
).
Nowadays of course, nobody cares what the absolute level of CPI
or PPI is. We only wish to know the rate of change, but it was not
always so.
Recently, while in the process of writing a synoptic history of
how the relationship between yields and inflation had changed in
the 1910s and then again in the 1960s, I almost inadvertently came
up with a kind of back-of-the-envelope equation for describing the
behavior of the one-year Treasury yield prior to the establishment
of the Federal Reserve.
As I went over the various permutations of that equation and
then extended it out over the entire period from 1871 to today, it
struck me that as clumsy, naive, and unlikely as the equation was,
it seemed to point to an equilibrium within the yield complex that
endured in somewhat aloof fashion from inflation and yet adjusted
to changes in the nature and behavior of inflation, as well.
I think this equation confirms that a) since the 1960s, the
yield complex has come to a new "understanding" with the inflation
complex, b) that the period between the establishment of the Fed
and the implosion of Bretton Woods in the 1960s was a chaotic
period of transition from one price regime under the gold standard
to the new, more inflationary price regime under the dollar
standard, and c) that the behavior of yields since the 1960s show
increasing signs that the post-Bretton Woods equilibrium is
unsustainable.
In that vein, although many people have complained that Treasury
yields, for example, are being held down to unnatural levels by the
Fed, history suggests that they are behaving more or less as they
have always behaved in great crises. It does not say anything in
and of itself about causation, but it does seem to suggest that we
may either be in the midst of a normal,
once-in-a-half-century-or-so systemic crisis or that we may be on
the cusp of a transformation in the global financial regime.
Coming to a fuller understanding of how interest rates,
inflation, and P/E ratios interact would likely permit us to
prepare more fully as investors and citizens for whatever the
future might hold.
In future articles, I would like to describe in greater detail
how the behavior of particular yields (and types of inflation) and
their relationships with one another have changed over the last 140
years, but in this article, I would simply like to present the
original equation I found and point to the initial questions that
it raises.
In the following charts, you can see how it models the S&P
earnings and dividend yields and the ten- and one-year Treasury
yields, as well as the relationship with CPI prior to the
establishment of the Fed.
I have no grand theories to back them up, only observation of
the phenomena. In the original variation of the model, which I have
termed "boe1" ("boe" as in "back of envelope"), the critical period
to pay attention to is the gold standard period when yields matched
the price level, although as I said, it does seem to hold up fairly
well over time.
(click to enlarge)
(click to enlarge)
(click to enlarge)
(click to enlarge)
Correlations by time period, yield, and model
|
Correlations
|
1872-1912 |
1913-1960 |
1960-2011 |
1872-2011
|
| EY vs CPI |
0.5 |
0.07 |
-0.39 |
-0.30 |
|
EY vs boe1
|
0.39
|
0.51
|
0.34
|
0.5
|
|
DY vs CPI
|
0.80 |
-0.21 |
-0.60 |
-0.69 |
|
DY vs boe1
|
0.35
|
0.68
|
0.80
|
0.69
|
| 10y vs CPI |
0.85 |
-0.19 |
-0.24 |
0.40 |
|
10y vs boe1
|
0.40
|
0.47
|
0.83
|
0.76
|
| 1y vs CPI |
0.59 |
-0.04 |
-0.39 |
0.1 |
|
1y vs boe1
|
0.36
|
0.35
|
0.57
|
0.58
|
The table of correlations suggests that as the relationship
between yields and prices deteriorated, the model's correlations
grew stronger.
A problem emerges though as we go into the equation, however. As
you can see from the charts above, the levels predicted by the
model are fairly random.
The equation is EY - DY = 10y - 1y.
As you can see right off the bat, it has something to say about
the spread between the yield curve, but before I get to that, I
want to get the so-called "Fed model" out of the way. The Fed model
equation can be expressed as EY - 10y = DY - 1y.
(click to enlarge)
In recent years, the spread between the earnings yield and the
ten-year Treasury, treated as an equity valuation tool, has been
ridiculed on the basis of a lack of historical correlations between
the two yields, and perhaps a narrow or absolutist application of
it has been unwarranted, but it does not appear to be wholly
random. If the earnings and ten-year yields have been uncorrelated,
perhaps it points to a deeper imbalance in the system. In any case,
the equation for the Fed model appears to hold up fairly well, with
a correlation of 0.72.
So that takes us to the much dicier problem of the yield curve,
which should be equivalent to the spread between equity yields.
(click to enlarge)
During the gold standard, the correlation between these two
sides of the equation was only 0.18. During the 1961-2011 period,
it had fallen to -0.23. What is more, even during the gold standard
period, the 10y-1y spread was almost always negative, while the
EY-DY spread was (and has remained) almost always positive.
Indeed, from 1871-1950 or thereabouts, every instance of the
Treasury yield spread going positive coincided with a bottoming and
sudden reversal in the EY-DY spread (which would tend to make the
correlation negative). After 1950, however, an upward sloping yield
curve seemed to have no such effect and perhaps even the opposite
effect.
In my next article (in this series), I intend to make amends for
this fault in the model by introducing a second variation of this
equation (boe2, if you will) that takes into account inflation. For
the period of 1961-2011, this second equation will solve virtually
every problem manifest in boe1, but it leaves or accentuates the
question as to why and how the relationship between equity yields
and the Treasury curve seem so tied to one another, in harmony or
in combat, depending on the perspective one uses.
In any case, as this series unfolds, I think we will find that
the behavior of the EY-DY spread is and always has been an
under-appreciated aspect of the yield complex.
Disclosure:
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours. I wrote this
article myself, and it expresses my own opinions. I am not
receiving compensation for it. I have no business relationship with
any company whose stock is mentioned in this article.
Additional disclosure:
I am short December S&P 500 futures.
See also
Merrily Going Off The Fiscal Cliff Together
on seekingalpha.com