The Fed raised the Fed Funds rate last week from basically free to 0.25%. More important, it said it would raise short-term rates six more times this year, and foresees another three or so for 2023. By New Years Day, then, overnight money will be at 1.75%, and will conceivably reach 2.5% by summer.
My sense, which isn’t worth much in the fixed income arena, is that the 15-month ahead target is a bit more aggressive than what the consensus had been expecting, Nevertheless, the stock market rose sharply on this news, signaling its approval of this more aggressive Fed plan.
What does this mean for the 10-year Treasury, the main alternative to stocks for us as investors? If we posit that the real (after subtracting inflation) yield on the 10-year should be 1.0%, this implies a nominal yield for the 10-year at 3.5% by next summer. Let’s say 4.0%, instead.
If we think the earnings yield (1/PE) on stocks and the interest yield on government bonds are more or less equivalent things, this implies the PE on the stock market should be somewhere around 25x.
Economist Ed Yardeni estimates the earnings on the S&P for 2022 will be $225/share. This would suggest the S&P at 5600, close to 25% higher than it is today. Put a different way, and assuming both that Yardeni is roughly correct and that the interest yield-earnings yield correspondence holds, the S&P is already discounting the 10-year Treasury at 5%.
For anyone caught up in the rough-and-tumble of daily stock market gyrations, Wall Street’s positive reaction to the Fed news might seem to be surprising upbeat. Three considerations:
–typically, the more bearish the market, the more willing investors are to refrain from their normal practice of acting in anticipation and to wait instead for actual events
–from the highs of late December to last Monday’s low, the S&P had dropped by about 13%. The 7% gain from then to the Friday close recovers only about half that loss and brings the index to roughly breakeven over the past half year; also,
–the most significant market damage has occurred away from the S&P. From 12/27 through last Monday, the NASDAQ was down by 18% and ARKK had lost 40%.