Since bottoming at a close of 0.54% on March 9, 2020, the 10-year US Treasury yield has slowly and quietly risen nearly 70% to 0.89% as of this writing. With the Fed holding short-term lending rates in the 0-.25% range, the slope of the yield curve has steepened dramatically as seen in the chart below. Many believed longer-term interest rates would rise off of the historical lows set during the panic at the start of the pandemic. However, the question now becomes, how far will longer-term interest rates rise?
Rising longer-term rates indicate credit markets are expecting an increase in economic activity as the economy recovers from the pandemic-induced shutdowns and disruptions. The magnitude of the move is a positive sign indicating the economy is likely to experience high economic growth. Along with this, bond investors are anticipating a corresponding increase in inflation – which is a positive given how anemic inflation has been over the past decade.
On the flip side, rising longer-term rates are inevitably negative for equity valuations. In essence, bonds are competing with equities for a finite amount of investor capital. Increasing bond yields may put a cap on equity valuations. Essentially, as the equity risk premium (the amount of earnings yield that investors demand over Treasury yields) increases, it’s difficult for equity valuations to continue to expand. All else being equal, as interest rates rise, the P/E on equities falls. We will cover this in considerably more detail in our First Quarter 2021 Wealth Report, but this is a trend that may cap equity valuations in 2021.