“Treasuries are at their lower bound from a price point of view, upper bound in terms of yield point of view.”
The 10-year Treasury is back above 4.6%, its highest level in four weeks, with oil climbing again and markets pricing better-than-even odds of a September rate hike. That spike has pulled the equity risk premium, the difference between the S&P's earnings yield and the yield on the 10-year Treasury, down close to zero. That metric has historically been positive, which makes sense if you think corporate profits are more risky than Treasury yields. The read on today’s situation is that stocks are priced for perfection and equity holders should be nervous.
You can see the risk premium fall in this chart from The Wall Street Journal.
Click to enlarge.
Peter Linneman reads the same chart from the bond side. The premium, he says, is "a backward looking crude inference of what people are doing," It isn’t driving things; nobody allocates off this chart, but what it records is real. Treasuries spiked on oil, war fears, and rate expectations that have swung from cuts to a possible hike, while earnings held. "Earnings are quite good." The compression in this metric came from changes in Treasury yields, not from anything equities did.
The premium runs positive for the same reason a commercial mortgage prices over Treasuries. "You are taking a risk, but if you underwrite it more or less correctly, you get a premium." Linneman puts the normal spread at a couple hundred basis points, maybe three hundred. Ask investors, with stocks at record highs, whether that premium is currently high or low, and most would guess very high. "And then you look at it and you go, No, not at all."
"Treasuries are at their lower bound from a price point of view, upper bound from a yield point of view."
When the equity earnings premium drops this far, it’s destined to correct. Every further tick up in the 10-year yield makes the bond a better trade against a fully priced share, and the marginal dollar pivots from equities into Treasuries. That pivot is a headwind against additional yield increases, which is why Linneman concludes that "Treasuries are at their lower bound from a price point of view, upper bound from a yield point of view." As yields ease, the premium rebuilds on its own.
For real estate borrowers pricing debt off the 10-year, the practical read is that the current benchmark sits nearer the top of its range than the middle. That argues for patience on refinancings that can wait a quarter or two rather than locking long-term fixed rates at today's quotes, and for underwriting exit cap rates against a 10-year that faces more downward pressure than upward from here.
From The Margins
A little of what’s out there.
The Pantheon in Rome has been standing for nearly 2,000 years. Its massive concrete dome remains the largest unreinforced concrete dome in the world.
Meanwhile, we spend a lot of time repairing concrete poured during the Reagan administration.
For years, researchers assumed Roman concrete lasted because of its volcanic ash. But scientists studying the material noticed something odd: tiny white chunks of lime scattered throughout it. They were long dismissed as evidence of sloppy mixing.
It turns out they may have been the secret.
Researchers found that when cracks form and water seeps in, these lime deposits can react and help fill the cracks with new mineral material. In other words, the concrete has a capacity to heal itself.
credit: news.mit.edu
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