License to Yield: How Bond Actions Affect S&P 500 (and Others)

It has been more than a decade since the first time negative interest rates were introduced in 2009, by Sveriges Riksbank, central bank of Sweden in overnight deposit rate. However, the real negative interest rate policy (NIRP) were introduced broadly since 2014, which was called one of the greatest monetary policy experiments. Later, it was adopted by Bank of Japan in 2016, in which ultra-low negative interest rates were already introduced previously in post-1997 Asian Financial Crisis period.

Euro area deposit facility graph (tradingeconomics.com)

Bank of Japan interest rate decision (tradingeconomics.com)

Negative Interest Rate Policy (NIRP)

The impact of negative interest rates introduction was large, mostly related to disbelief given psychological floor of “Who would lend at negative interest rates anyway?”. Put it in normal daily conversation, “Excuse me, would you lend me money, with condition that I’ll pay less of what I borrowed somewhere in the future?”. But, since the introduction, people were growing accustomed to it, to the point that negative rates has entered personal/retail banking territory, in this example from 2019 is negative mortgage rate in Denmark.

This trend apparently persists, as my LinkedIn feed for the last months was filled with the success story of negative-yield bond issuance, such as the ones by the Kingdom of the Netherland or, lately, by Kingdom of Saudi Arabia.

40% Bonds, 60% Stocks.. Still Valid?

Unfortunately, US bond market (or central bank) did not respond in the same way, as since its introduction, we can see that not everyone in the US is a fan of negative interest rates. Last year (2020), veteran investor Ray Dalio of Bridgewater Associates, largest hedge fund in the world, explained that holding zero or negative interest rates bonds is pretty crazy move. His warning was interesting. But, since he also preferred to holding stock, it seems that he overlooked the complete story.

Before Dalio’s comments, back in March 2018, Jeffrey “Bond King” Gundlach warned market with all types of risky assets will be in turmoil if the 10-year treasury yield hit above 3%. This turned out to be the case, looking back to what happened in 2018, especially in Q3-2018 (see yellow box below, area is 10yr US Bond yield, line is S&P 500 index).

Why 10-year yield matters to stock market? Large institution investment strategy is not the same as retail traders. In addition to return, they also consider risk associated to each investment, and/or asset class, quantified by risk measures such as volatility, Value-at-Risk (VaR), Expected Shortfall (ES), or maximum drawdown (MDD). To be consistent with the investment mandates they received from their investors/clients, their investment strategy should be focusing to have portfolio with relatively higher return than effective yields or risk-free rates, with stability for long-term horizon. This is in contrast to daytrader style of spectacular returns, yet ultra-volatile (yes, GameSpot and Bitcoin are prime examples). So that was in 2018, but we can use the gist of the story to explain Thursday’s movement:

For professional investors, optimizing long-term investment returns/yields with stability (low volatility) is the key

That is the reason why normally 40% stocks and 60% bonds holding were followed, to balance the risk and return between the two asset classes, with stocks as the risky asset type. However, we also need to understand that stock investment is not all about the grow in value of a stock, but also dividend associated with holding the stock. Below is the dividend yield statistics from YCharts, with explanation:

“The S&P 500 Dividend Yield, as calculated by the S&P 500 Dividends Per share TTM divided by the S&P 500 close price for the month, reflects the dividend-only return on the S&P 500 index. The S&P 500 index is a basket of 500 large US stocks, weighted by market cap, and is the most widely followed index representing the US stock market. After the financial crisis of 2008 the yield value decreased from a peak of 3.86% in 2008, to hovering around 2%, on average, for the next 10 years.”

S&P 500 Dividend Yield is at 1.57%, compared to 1.55% last month and 1.81% last year. This is lower than the long term average of 1.87%.

This means, as the 10-years yield going up, the motivation to hold stocks is becoming less and less looking at how risky assets are not yielding that much compared to 10-years yield. This is more evident as on Thursday (February 25th), US 10-years yield was briefly above 1.50% (1.563% to be precise), which is already above December 2020’s S&P 500 dividend yield (1.55%) and just less than 1 basis point to January 2021’s S&P 500 dividend yield level. Meaning, for very brief moment on Thursday, give or take, by taking risk premium into account, US 10-years risk-free rate is already above S&P 500 dividend yield level. Despite the motivation behind bond market move last Thursday, this event is making the standard40% bonds / 60% stocks standard allocation strategy is not really valid anymore, as 10-years yield is dragging down along stocks together with bonds (remember the inverse relationship between bond price and yield). At the same time, also questioned Dalio’s preference to hold stocks, without considering the effect of a bullish yield scenario impact on stock market.

The Bullish Case of Interest Rate / Yield

In Q1-2020, when the sell-off happened, US 10-year yield was at its lowest point since, like, ever.. This reflect the flight-to-quality textbook reaction when Covid-19 getting its pandemic status. For bond bulls, looking at Fed funds futures last year, the idea of effective Fed funds rate turning sub-zero was getting more convincing with Covid-19.

However, turns out that Fed insisted that they won’t acknowledge negative rates regime as a standard norm, at least in the US. This is eventually confirmed by Powell’s comment last week that they will keep rates at 0%-0.25% range for longer period.

This is an official confirmation that 0% is the official floor level of US yields, crushing NIRP speculation on US economy

As the US yield finding its official floor for longer period, expected inflation seemed to also found new floor in Q1-2020, as indicated by Thomson Jeffries CoreCommodity CRB Index below. If we follow standard textbook monetary policy, though it is never completely clear which follow which, in the expected inflation and effective rates case, very likely we will see pre-corona US 10-year yield in the near future as indicated below from post-2008 crisis move. With both yield and commodity index both moving up after finding floors in Q1-2020, it is very likely that US 10-years yield may touch 2% in the near future and rising well above S&P 500 dividend yield level.

License To Yield

The money that portfolio managers have in their books are not free money, they come with a mandate, a license to yield. They are always looking for the longer term yield with stability, as outlined in their investment mandates to balance risk and return. Given high P/E ratio reading is above 30 (34.24 as of September 2020 for S&P 500 index constituents) despite low dividend yield, they should be cautious as US 10-year yield is going up and, very likely surpass S&P 500 dividend yield soon. Plus, with S&P 500 newcomer (Tesla) stock P/E ratio just below 1000 without dividend paid so far, I doubt S&P 500 in good condition when US 10-year yield rising further up, same bad omen goes with other non-yielding assets (e.g. Gold and, possibly, Bitcoin).

On the other side of the ocean (Europe), however, situation seems milder as German DAX constituents’ dividends still yielding a handsome 2.2% with German’s 10-year yield at subzero around -0.3% right now (Thursday, 3 March 2021).

With more than 200 basis points gap between DAX index and 10-year Bund yield, it’s a completely different story for German’s market (read:Europeans) compared to S&P 500 right now

This situation may reverse the relative trading strategy of US vs EU stock indices trend that has taken place for more than a decade now, but this is different story for another time!

___________________________________________

Gior Simarmata is a risk/finance professional located in The Netherlands. He has worked as a senior risk advisor with ING Bank N.V. in the Risk Management Department, responsible for the risk reporting and analysis over the XVA portfolio of the bank’s global derivative positions. He started his career in The Netherlands banking sector with Rabobank as Product Controller in the Finance and Risk Center Department, with trading desks reporting and control responsibilities covering Equity Derivatives, Commodity Derivatives, and Group Treasury’s Structured Notes portfolios. Prior to leaving Indonesia for his master study, he worked with Standard Chartered Bank in Jakarta as a management trainee.

You can reach me by email: giorevinus.simarmata {at} finrisk.eu

This article along with my other articles are also available in LinkedIn and Medium