Looking back over the history of bond and equity markets since the late 1980s we observe a secular decline in Treasury yields and corresponding rise in equity prices – which largely reflects expanding P/E multiples (i.e., share price relative to earnings). Since the beginning of this year, however, 10-year Treasury yields have risen to 2.8% thereby breaking above a three decade-old downtrend line. (See our previous Feature - A Longer-term View). Contributing to this has been passage of the lower tax bill without corresponding reductions in government spending at this advanced stage of the business cycle – implying much greater funding needs and deficits going forward.
An end to the secular decline in bond yields with an initial leveling off between 3.5% and 4% suggests that current P/E’s are too high and equities overvalued. The unintended consequence of recent tax policy, putting greater upward pressure on bond yields, may thus be to significantly increase the risk to equity markets and the economy.
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