Control Panel: Interest rates & stock duration

The big news last week was the completely predicted increase of the fed funds rate by 0.25%. Fed Chair Jerome Powell expressed his admiration for Paul Volcker. Will Powell and the rest of the Fed actually raise the real yield of the 10-year Treasury from -1% to +2.5%, the historical “neutral rate”? That is a huge change which will wipe out $billions from existing bond portfolios.

A Treasury with a real yield of 2.5% will be a serious competitor for stocks in many portfolios. The demand for stocks will decrease since “TINA” (There is no alternative) will fade. Shareholders will find that stocks will decline by varying amounts.…

**As central banks start lifting borrowing costs from near zero, profitless startups are certain to suffer more than telecom companies. For everything in between, investors should learn to look at stocks as if they were bonds.**
**By Jon Sindreu, The Wall Street Journal, March 20, 2022**

**What about stocks? While they offer much more legroom than bonds to speculate because payments aren’t fixed, their value is — usually — still tied to expectations of making a profit. Mature businesses with predictable dividend payments can be seen as having low duration, whereas growth-led firms have more of their value tied to earnings in the distant future. Startups have extra-long duration: They are akin to buying a lottery ticket with a payout in 10 years’ time.**

**Most stocks, however, fall somewhere in between, which requires going beyond intuition or sector correlations with bond yields....**

**In a 2004 paper, University of Michigan researchers Patricia M. Dechow, Richard G. Sloan and Mark T. Soliman popularized a way to estimate a company’s “implied equity duration” by predicting future cash flows based on the growth of sales, earnings and book value. Applying their math to S&P 500, Euro Stoxx 50 and FTSE 100 stocks puts the duration of blue-chip stocks at around 20 years. As expected, the consumer services, healthcare and tech sectors, which have done better in the period of rock-bottom borrowing costs, rank above average [longer duration], while energy, finance and telecommunications are below [shorter duration]....** [end quote]

This article has the duration of 638 stocks. Duration is only one factor, since profits, strong balance sheets and other considerations dominate duration. However, a long-duration stock with a weak balance sheet, high P/E, no profits and no dividends will be hard-hit when interest rates rise.

Many stocks have had rising durations during the recent regime of ultra-low interest rates. This is reflected in the P/E bubble.

Stocks bounced back a little this week as the Fed acted in line with expectations and the price of oil subsided somewhat.

The trends of falling stocks, rising Treasury yields, rising oil and natgas prices still hold. The trade was risk-on as stock and junk bond prices rose relative to Treasuries, but this is just one week so it may be (probably is) noise. The Fear & Greed Index improved to Fear. VIX dropped but it’s still high.

The Treasury yield curve rose and flattened. The 10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity headed toward zero. Since 1975, it has only gone negative a few months before the start of a recession. Recessions also tend to occur after several rounds of Fed tightening.

The whole point of the Fed’s tightening is to reduce demand in order to restrain inflation. It’s going to be tough to reduce demand just enough to tame inflation without also causing a recession.

We are all aware of the world events that can impact the Macro economy. The Russian invasion of Ukraine. The potential for China to help Russia, causing secondary sanctions that could have a “cut off our own nose” impact on the U.S. economy. The receding Covid wave which could cause people to drop their precautions just as the new BA.2 omicron variant arrives from Europe.

It’s possible that the markets have absorbed all this and simply chose to ignore it.

The METAR for next week is unsettled, very typical for spring weather. Expect volatile ups and downs. It will take several more weeks to establish a new trend with all this noise – if a new trend emerges. The current trends still hold until the signal overcomes the noise.



I expect this to be among the more well-remembered forecasts in time. That is, I expect it to appear prescient, even understated. In its context, it makes perfect sense, but it is only at these inflection points that your persistent acumen is at its brightest contrast from the complacency of crowds. Thank you, Wendy, for providing that rare voice of calm reason in the midst of the gathering storm.