As part of today’s policy statement, the Fed released a packet of economic projections from its 16 top officials. Included in the packet is a long term projection for the Fed Funds rate. Today’s packet showed that on average Fed members believe that 3.88% is the appropriate long term level for Fed Funds (5-6 years from now).
It’s worth noting that 3.88% is more than 1% higher than the current yield on the 10 year treasury note and even slightly higher than the current yield on the 30 year treasury bond. Historically the 10 year and 30 year have traded at a 1.61% and 1.89% spread to Fed Funds respectively, so Fed guidance implies that the yield on the 10 year note should rise to 5.49% and 5.77% for the 30 year bond.
Compared to those levels, equities would need to be re-priced as well. The operating earnings yield on the S&P 500 is currently just 5.73%, which is a reasonable spread if interest rates stayed here forever, but clearly doesn’t look as strong if interest rates were to rise.
Equities are as long term of an asset class as it comes and should be priced relative to long term expectations. At 5.7% earnings yield one could argue that they aren’t. If the 30 year bond were to rise to 5.77% (as implied by the Fed’s long term forecast) and equities maintained their current yield spread to the 30 year bond (2.05%), the earnings yield on equities would rise to 7.79%. That’s equivalent to a 12.8x earnings multiple or 1373 on the S&P 500, a 26% decline from today’s levels.
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