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Bond Yields, Earnings Yields and Inflation

William Hester, CFA
February 2010
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For the second consecutive week, bond yields moved higher through Friday, tacking on 20 basis points from their recent low. Yields are up 60 basis points from their December low. A lot was thrown at bond investors this week, including a year-over-year change in the Producer Price Index of 4.6%, which was above consensus, and the news that China's Treasury holdings fell by $34 billion in December to $755 billion. That drops China from the top spot as the largest foreign holder of US Treasuries.

The CPI came in at a more mild 2.6 percent year-over-year change, down slightly from last month's 2.7 percent. Investors may want to hope that this moderation in the volatilty of inflation continues. The graph below shows the 36-month rolling volatilty of inflation. It picks up the quick shifts in the level of inflation we've seen, including the changes in price levels peaking out in 2008 at 5.6%, price declines of more than 2% through the middle of last year, and the recent return of rising inflation the last few months. It also gives some historical context of how volatile the changes in the rate of inflation have been of late. The current level of inflation volatility ranks behind only three other periods since 1950: the early 1980's, the mid-1970's and the early 1950's.

As I noted in Secular Bear Markets and the Volatility of Inflation , the uncertainty brought about by large swings in inflation is often harmful to investors. As the level of volatility in inflation (and GDP, for that matter) increases, investors become less confident in the real cash flows that will be earned, so they will typically mark down the P/E multiple on stocks. The graph below compares the volatility of inflation against P/E multiples. As the graph shows, following periods of very low economic volatility, investors tend to overprice stocks (and subsequently earn below-average returns). Investors press stock valuations lower in response to periods of large amounts of uncertainty (typically leading to above-average long-term returns).

There's something else of interest in the graph, and that's where the most recent data points are. I've highlighted the last six months of data in red. As you can see, we've moved into a rare area on the graph where valuations are far above their typical levels for the current level of economic volatility. Investors usually only award stocks these levels of valuation when the economy has been on a very smooth and predictable course. If the Great Moderation II is not immediately ahead of us, stocks look overvalued based on current levels of economic volatility.

Bond Yields & Earnings Yields

Inflation is not a likely outcome in the near term, especially if the second round of mortgage interest-rate resets ignites another rush into safe-haven investments such as Treasuries. But higher inflation is more likely further out as the government issues more securities to cover mortgage losses and continuing budget deficits. John Hussman has noted that investors can't rule out a doubling of the consumer price index over the coming decade, beginning a few years out.

During that time period, in addition to the level and volatility of inflation, investors may want to watch how bond investors react to trends in inflation. That's because bond yields and stock valuations tend to track each more closely at higher levels of inflation. The graph below shows the 36-month rolling correlation between the changes in bond yields and earnings yields. I've used earnings yields in this analysis to pick up both changes in stock prices and the levels of valuation. The graph shows that over the last few years, bonds and stocks have mostly parted ways. In 2007 and 20008, as investors panicked about credit losses and deflation, they sold stocks and bought Treasury bonds. This also happened during the 2000-2003 bear market.

The graph also shows that the recent inverse correlation is as stretched as it typically becomes. These periods of strong inverse correlation are typically followed by periods of higher positive correlation. For a large part of the historical data, bond yields and earnings yields tended to move more closely together.

A tighter positive correlation between the two might be also be spurred on by a rise in the rate of inflation. The graph below compares the year-over-year change in the CPI with the correlation of the changes in bond yields and earnings yields. The graph was created by ranking the changes in CPI highest to lowest, breaking this list into groups, and then averaging both the CPI and correlations for each group. The graph shows that higher levels of inflation often coincide with higher levels of positive correlation between the changes in bond yields and earnings yields.

During periods of low inflation, the correlation between bond yields and earnings yields typically collapses, or even goes negative. Stock investors typically bid up the valuations on stocks during these periods and become much less sensitive to the changes in yield levels. As inflation rises, stock investors again become more sensitive to the views of bond investors.

Higher rates of inflation and rising levels of correlations between the changes in bond yields and stock yields don't sound like a good combination, and it turns out that they're not. It's important to keep in mind that the process is a journey, typically beginning at low levels of inflation and continuing as the rate of inflation rises. Investors don't typically wait for high levels of inflation before adjusting stock valuation multiples lower.

The set of graphs below are created the same way as the graph above except that instead of using the level of inflation to create the groups, I've used the 12-month change in inflation. Not surprisingly, both charts show that when inflation is climbing both bond yields and earnings yields tend to be pressured higher. Generally, when inflation is falling bond and earnings yields also decline. And the relative changes in yield levels for both bonds and stocks tend to be commensurate with the change in the level of inflation during the same period.

Inflation is not a likely outcome in the near-term. For now, credit risks are likely to be of concern to investors until the economy gains a better footing, and these risks can move stocks and bonds in different directions. Longer-term, investors should be alert for rising inflation. At that point, stock investors may want to be particularly sensitive to any changes in the level of bond yields, because the correlation of the changes in bond yields and stock yields will likely rise along with inflation. Most importantly, stock valuations generally suffer through the entire process of rising inflation, rather than simply responding to the end result.


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