Sunil Kewalramani: The 'reversing yields' conundrum

Sunil Kewalramani / New Delhi December 22, 2008, 0:18 IST

Given Japans reverse yield gap, is it safe to assume its malaise of deflation and low
economic growth has been exported to the western world.
The gap between bond and equity yields is becoming a critical issue in the world
financial markets. According to this valuation model, popularly known as the Fed
model, in equilibrium the real yield on the 10-year US Treasury Bonds should be similar
to the S&P 500 earnings yield (that is, S&P forward earnings divided by the S&P level).
Differences in these yields identify an over-priced or under-priced equity market. More
specifically, if the S&P earnings yield is higher than the treasury yield, investors should
sell treasuries and buy stocks (i.e. stocks are undervalued), while if the S&P earnings
yield is lower investors should sell stocks and buy the more attractive treasuries (i.e.
stocks are overvalued).
Until 1959, equity yields were in excess of bond yields both in the US and UK. The
reason being investors had to be rewarded for the extra risk he/she took to invest in
equities, known as the equity risk premium. After 1959, equity yields were below bond
yields. This was because, as Professor Paul Marsh of the London Business School
explains, the yield gap equals the expected risk minus premium on equities the expected
growth in dividends, which tend to rise with inflation. It may be recollected that in order
to arrive at the equity yield, investors notionally add a risk premium to the bond yield.
Therefore, inflation and growth are both crucial in determining whether the yield gap is
positive or negative. The higher the inflation and growth, the more equity yields will be
below the bond yields.
Of late, the dividend yield for the S&P 500, currently at 3.45 per cent, has risen above the
yield for the 10-year Treasury note for the first time in a long period of 50 years. In the
UK, the FTSE 100 dividend yield is at 6.24 per cent, much above the UK 10-year Gilts
yield of 3.74 per cent. Are there any ominous portends of this once-in-fifty years
phenomenon?
Resurgent bulls view this as evidence that stocks are undervalued and offering investors a
once in a generation buying opportunity. The bears on the other hand believe that
corporate dividends are going to fall sharply, as the message from lower bond yields is
one of weakening economy, well into 2009 and beyond, as collapsing corporate profits
begin to take centre-stage. To further their argument, they point out the dramatic collapse
in commodity prices from their highs reached earlier in 2008. The inflation data coming
out of the US and UK shows that even Consumer Price Indices have begun to decline.
This disinflationary trend, according to many economists, is expected to gather
momentum. In other words, the risk of inflation has been priced out of the US bond
market. The current low 10-year Treasury yield thus reflects the removal of customary
inflation premium. Fear of deflation has now hit the bond markets and policymakers. The
fact that the US Fed plans to buy $500 billion of mortgages to salvage the beleaguered

housing sector has added to the woes and caused the 3 per cent threshold for 10-year
long-term US rates to be broken.
In an April 2008 draft of their paper entitled Inflation and the Stock Market:
Understanding the Fed Model, Geert Bekaert and Eric Engstrom carefully re-examine
mechanisms that might explain why the Fed Model works. Using quarterly inputs for
bond yield, S&P 500 index level and dividend yield, the economic forecast and a
consumption-based measure of risk aversion spanning the fourth quarter of 1968 through
2007, they conclude that:

The correlation between the stock dividend yield and the bond yield is 0.78 over the
entire sample period.
Most of the movement of these yields derives from the fact that economic uncertainty
(among professional forecasters) and (consumption-based) risk aversion are high when
expected inflation is high. High uncertainty and risk aversion rationally drive the equity
yield up, and high expected inflation rationally drives the bond yield up.
Other countries in which high inflation tends to coincide with high economic
uncertainty/risk aversion (stagflation), as experienced in the US, also have relatively high

correlations between bond yields and equity yields.

Money illusion plays no more than a small part in the relationship between stock and
bond yields.
The chart, taken from the paper, plots the equity yield and the bond yield from the fourth
quarter of 1968 through 2008. The equity yield is the aggregate dividend yield for the
S&P 500, and the nominal bond yield is that of the 10-year constant-maturity Treasury
note.
In summary, the high correlation between equity yield and bond yield derives rationally
from the tendency for inflation to be elevated during recessions, such that both equity and
bond premiums are relatively high during recessions.
Japan has a reverse yield gap. Can we therefore assume that the Japanese malaise of
deflation and low economic growth will be exported to the western world? In a chart
plotting the Japanese yield gap with nominal GDP growth over the past decade also
known as the lost decade for Japan, it was concluded that for nominal GDP to shrink,
both inflation and growth must be negative. Peter Eadon-Clarke of Macquarie Securities
points that when nominal GDP is negative, the Yield Gap also tends to be negative. In
Global Investment Returns Yearbook by Dimson, Marsh and Staunton, 2008; Professor
Marsh has shows that both dividend growth and inflation were higher in the second half
of the last century than in the first.
The current steep fall in Treasury Bond yields across the developed world does indeed
suggest that investors fear deflation, while the steep rise in equity yields suggest that the
investors fear a sustained collapse in dividends as also a higher risk premium for equities.
Reality, however, tends to indicate that low bond yields are because the investors have
become risk-averse and need security. At the same time, enormous amount of new bond
issuance is likely across the frontiers of the world as governments try to recapitalise
banks and reflate their respective economies. At the same time, the cost of insuring UK
government bonds against default have risen from 8 basis points in February 2008 to 110
basis points today. This shows that even bonds are not regarded as being absolutely safe
for investors.
In the boom years, risk was ludicrously underpriced. Understandably so, we should now
expect it to be become overpriced by a similar magnitude. After reversion to the mean,
bond yields should recommence their upward ascent. Simultaneously, equity yields might
also fall, to the extent to which investors regain their lost appetite for risk.
The author is a Wharton Business School MBA and CEO, Global Capital Advisors