Interest rates are rising all over the world, and the impacts on equity valuations will be massive as stocks will have to revalue inferior. This week could be one of the most critical weeks for rates, with a 10-year auction on Feb. 9, a CPI printout on the morning of Feb. 10, as well as a 30-year auction. later in the afternoon.
Additionally, rates in Europe are rising as the ECB pivots and opens the door to potential rate hikes as early as this year. German interest rates are now trading at their highest levels since 2019 and are poised to go even higher. This was perhaps the most important development in the last week that everyone missed because they were too busy paying attention to quarterly results from Meta (FB) and Amazon (AMZN).
The German 10-year is now poised for a massive jump if it manages to breach the resistance at 26 basis points. It has the potential to move up to 60 bps. A move of this magnitude is significant because the days of ultra-low rates in Europe suppressing US yields are now over.
These rising European rates are helping to push US 10-year rates higher and above the all-important 1.95% level. With this crucial resistance level currently breaking, the 10-year rate is likely to climb well above 2% and potentially as high as 2.15%.
The higher nominal rates are helping to pull the 10-year TIP rate to -0.45% and likely on its way to -0.30%. Meanwhile, the 5-year TIP likely still has a lot to rise from its current level of -0.89% to potentially -0.5%, after breaking above resistance at -1.20%.
Higher rates will drive down inventory
As rates rise, the pressure on equities increases, especially as real yields continue to climb. This will help push the PE ratio of the S&P 500 and the Nasdaq lower and higher incomes, which has already started to happen. For example, the 10-year TIP rate rose to -0.45% from -1.20% in November, pushing the Nasdaq earnings yield to 3.51% from 3.06% in November.
But the biggest move was in the 5-year TIP, which rose to -0.89% from -1.93% in November. The technical chart above suggests that the 5-year TIP could rise another 40 basis points to rise at least in the near term.
The gap between the Nasdaq yield and the 5-year TIP is now 4.42% and heading lower. Assuming the 5-year TIP rises to -0.5% and the Nasdaq valuation remains unchanged, the spread would fall to 4.03%, which would equate to where the spread was pre-COVID at the end of 2019.
But if the Fed is as aggressive as investors expect, then the real 5-year yield should not stop rising once it hits -0.50%. In fact, in 2019, the 5-year TIP had a yield of 5 basis points, which is 95 basis points more than the current value. This tells us that NASDAQ earnings yields will increase over time as real yields increase, even if they are not increasing point by point. Even a 40 basis point increase pushes the Nasdaq earnings yield to 3.95%. It doesn’t look like much. When you reverse that earnings yield and change it to a PE, you realize this is the case, with that ratio falling to 25.3 from its current 28.3 or 10.6%. A full 95 basis point rise in the earnings yield of Nasdaq would push it up to 4.5%, or a PE of 22.2, or 21.5% lower than its current value.
This is very tricky, but if you assume that rates are rising and potentially much higher, then stocks will only have one way to go, which is lower. In all of this discussion, we don’t even consider the effects of rising rates on financial conditions, which will make them more difficult, and its negative impacts on stock market valuations, such as the removal of leverage.
Higher rates mean the game is over for equities, and big rallies will only fade and hit lower lows. The only thing that will save stocks is if the Fed and the ECB become dovish again. Given current market levels, this doesn’t seem likely to happen anytime soon, it will take a much larger market correction for another central bank pivot.