The financial markets consist of numerous asset classes. From cash and bonds to stocks and commodities, capital owners have a variety of places to park their dough. Rather than analyzing the merits of one asset in isolation, veteran investors are continually assessing them relative to each other. Sometimes stocks are more attractive than bonds. And sometimes cash is more attractive than stocks. One of the most popular ways to analyze this relative attractiveness is through the lens of interest rates.
A rise or fall in interest rates can shift the perceived risk-reward of each asset.
When rates are high, cash is sexy. When rates are low, cash is stinky.
When rates are high, stocks are stinky. When rates are low, stocks are sexy.
When rates are high, bonds are sexy. When rates are low, bonds are stinky.
Savvy investors compare the rate of return in cash (what you get in a savings account, short-term CD, or short-term treasuries) to that of stocks and bonds. The rate of return on stocks is known as the dividend yield, and the return on bonds is known as the bond yield. Imagine the following scenario:
Cash Interest: 5%
Stock Dividend Yield: 2%
Bond 10-year Yield: 4.5%
Which asset looks the most appealing to you? (I say cash). Now, what about the following?
Cash Interest: 0%
Stock Dividend Yield: 2.5%
Bond 10-year Yield: 1.8%
Stocks look a lot more attractive here, don’t they? One of the easier ways to illustrate the changes in the appeal of one asset to another is overlaying them in a price chart. Check out the following which shows the yield on two-year Treasuries (i.e., what the Government will pay you to borrow money for two years) and the current yield on the S&P 500.
Notice how the 2-year yield (now at 2%) has finally climbed above the S&P 500’s dividend yield. This is the first time the 2-year has yielded a better return than stocks since 2008. While it doesn’t necessarily spell imminent doom for equities, it does reflect that the allure of bonds versus stocks is shifting. There will come a tipping point where bond yields are high enough to begin drawing serious money away from stocks. Whether that point is a 2-year of 2.5% or 3% or 4% remains to be seen. Admittedly, the current yield of 2% is still extremely low by historical standards so we could have a ways to go before higher rates take the wind out of the stock market’s sails. Nonetheless, it is something worth keeping an eye on.
