The US administration wants rates down.
What does that mean for the stock market?
Disclaimer: The information contained in this article is not and should not be construed as investment advice. This is my investing journey and I simply share what I do and why I do that for educational and entertainment purposes.
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TLDR Summary
The new US administration is determined to get interest rates down. It appears to be one of their primary policy goals. If they accomplish this goal, they will reverse the transformation of the US economy that happened after 2020. Beforehand, it was a low growth, low rate economy. Then it became a high growth, high rate economy. This fueled the 100% run of the S&P 500 over the last five years. Reversing this will very likely rerate the US stock market much lower.
Given that the stock/bond pain trade is likely over, fundamental consideration can matter again for both asset classes to find a reasonable return combination that matches their risk profiles. A simple historical return comparison suggests that 3-4% Treasury yields may meet the S&P 500 at about 5,000. And that grants stocks a very high generous premium.
To opine on a likely equilibrium between both asset classes, it helps browsing through the various macro themes they have been subject to in recent history. The 2010s conditioned investors into the believe that persistent low interest rates are inevitable and that they are bullish for stocks. Inevitable for demographic and technological reasons. And bullish because they raise the present values of future cash flows and thus justify higher multiples. They encourage investment and consumption and hence earnings growth. And they make equity dividends more attractive vs. fixed income instruments. This belief got crushed in 2022 when low rates proved to be less persistent than everyone believed.
This gave rise to a new consensus, namely that the low rate free lunch was over. Inflation was entrenched and hurt both corporate profits and the present values of fixed income streams. Investors dumped stocks and bonds. Somewhat ironically, cash received love in the middle of the worst inflation shock in decades. Cash during inflation - bizarrely the best and worst of all times to hold it. This economic pessimism got proven wrong quickly when stocks suddenly started running in spite of high interest rates.
Public deficit spending reaccelerated and proved to be a powerful bull market driver. A magic wealth creation machine that can pump private sector incomes and asset prices, from some time seemingly with very limited negative consequences in the form of inflation. High interest rates became part of the bull market cocktail. A new term was coined to describe this phenomenon: Fiscal Dominance. Betting on fiscal liquidity creation was very profitable for the last two years. That it will continue to work forever has now become the new consensus.
For this to be the case, politicians must continue to disregard inflation risks in their public spending binge. Given the strong aversion against inflation in the population, I consider that premise highly unlikely. Trump is sending clear signals that he is taking this issue very seriously and that he is willing to sacrifice the US stock market in the near-term. Realizing this gives rise to the last possible combination of stock market and rate expectations: Negative on both. I call it GFC doomerism and it couldn’t be less popular in my opinion. That raises the odds that it will actually prove on point.
The rate obsession of the new US administration
Scott Bessent, the new Secretary of the Treasury, has repeatedly emphasized that the Trump administration is determined to get interest rates down, for example in this interview. In my opinion, this objective is the result of their realization that the trajectory of the CPI will determine Trump’s legacy like no other metric. The Democrats’ failure to manage it is one of the main reasons Harris lost (I know they made numerous other mistakes as well).
Americans hate nothing with more passion than inflation. There is a strong consensus that temporary economic pain is warranted to get it under control. And the problem has become acute again. The most recent deficit acceleration since October 2024 has found its way into CPI prints. It’s risking a repetition of 2021/22.
Therefore, let’s assume that the new US administration is serious about their goal of getting rates down. What would the implications be? As you may recall, I have often emphasized that nominal GDP growth is by far the most important determinant for Treasury yields. Whether it’s due to real growth or due to inflation, the more GDP grows, the more will bond investors demand in returns, either to be compensated for foregoing superior returns in productive assets or for bearing inflation on their fixed income claims.
You may like a policy goal that emphasizes to grow real GDP while reigning in inflation. But we look at asset prices in nominal terms which is why nominal GDP growth determines their trajectory more than real GDP does.
From 2019 to 2024, the US economy was transformed from a low (nominal) growth & low rate economy to a high (nominal) growth & high rate economy. I don't think it was orchestrated intentionally by anyone, but it was the combined outcome of all policy decisions we have seen over the last years.
In my opinion, it's not debatable that this contributed significantly to the doubling of the S&P 500 during that period. Now, the current administration is determined to transform it back to a low growth & low rate economy. If accomplished, it seems obvious to me that this would rerate the US stock market much lower. How much lower though?
Where will the stock market meet the bond market?
You might remember the chart below from a previous article that I have written when discussing the valuation imbalances between (US) stocks and bonds. It divides the S&P 500 total return index by a hypothetical perpetual Treasury bond that I calculated by compounding every day at the prevailing 10-Year Treasury yield.
This chart is (and should be) upward sloping. Equity investors must be compensated for bearing additional risks that bond investors are not exposed to. They provide capital to productive assets that can fail. The slope of this chart has a name in finance that you are probably familiar with although you are probably used to derive it differently. It's called Equity Risk Premium (ERP).
Nobody knows the fair level for this ERP for sure. It depends on how and over what periods you measure it. For illustrative purposes, I have included 3% and 4% ERPs in the chart. 4% is highly ambitious. Stocks were tracking above that only briefly at the peak of dotcom. 3% seems more realistic assumption. However, the US stock market has diverged from it so far that it seems unreasonable to believe we will rerate to it anytime soon.
As of today, stocks are 16% ahead of the 4% ERP trendline and 114% ahead of the 3% trendline. As I have pointed out in the past, stocks have run so far vs. bonds because bonds were hopelessly overweighted in investor portfolios in 2023 and 2024 because of the misguided idea that rate hikes would crash the economy. The market had to force a rotation from the latter into the former to heal that imbalance.
Let’s assume the stock/bond ratio will meet at 4% ERP within one year. The bond market would then have to outperform the stock market by 16%. There is an infinite number of solutions to that equation. Bonds could rise faster in value than stocks. They could rise with falling stocks. And they could fall at a slower pace than stocks.
The S&P 500 is currently at 5,730 and the 10-Year Treasury Yield is at 4.22%. If the 10-Year Treasury yield stays at about 4%, the S&P 500 would have to drop to 4,885 to drop back to the 4% ERP trendline. If yields rise to 6%, it would even have to drop to 4,275. If rates dropped to 2%, the S&P 500 would only have to drop to 5,596.
If you ask me, I find it most plausible that we will end 2025 with the 10-Year Treasury yield somewhere between 3% and 4% with the S&P 500 at about 5,000.
Interest rates and the stock market - which camp are you in?
I can imagine that you don’t care much about bonds. Surely you care about interest rates like many people do, especially since they were so volatile in the last few years. But that does not necessarily mean you would consider bonds as an investment. First, a decade of ZIRP and QE pretty much removed them from your investment menu. Then the bond bubble burst, inflation surged and now bonds are considered money furnaces. And even if they are not, why would you collect just 4-5% annually if you can gains multiples of that in stocks and crypto?
However, in spite of their bad reputation, bonds are actually a cornerstone in most investors’ asset allocation. The global bond market is even bigger than the global stock market ($141tn at the end of 2023 vs. $115tn global equity market cap). Most investors have to have an opinion whether they like one more than the other or whether they don’t like either.
I believe there are four camps anyone could be in with respect to their interest rate expectations and their affection for stocks. I believe that it is helpful to map them to avoid getting stuck in the camp that is deeply in consensus right now. Ideally, you want to be in a camp that is less popular right now. Of course, you shouldn’t be contrarian just for the sake of it. But staying away from consensus views raises the odds of generating alpha.
Firstly, you may be bullish stocks with the expectation that rates will stay elevated. That would be the Fiscal Dominance paradigm in which the government can and will pump asset prices through deficit spending without much interest in controlling inflation. Higher rates are boosting asset prices because they increase deficit spending and - in the case of the US economy of the 2020s - they are ineffective in curbing consumer spending because households don’t have much debt and to the extent they have, it’s termed far out at low rates.
I was in that camp for most of 2023 and 2024 as you may recall from dozens of articles on the matter. I believe that this camp is in for a rude awakening. The US population is clearly highly inflation averse as evidenced in the result of the presidential election and the bad reputation of public deficits and debt outstanding. If Trump has understood one thing, then it’s in my opinion that his legacy will be determined by one metric more than any other one: the CPI level in December 2028. He will optimize for that above anything.
Secondly, you may be bearish stocks with the expectation that rates will stay elevated. It’s the 1970s stagflation idea. This point of view was very popular in 2022. Look at what investors liked at the bottom in 2022. Reality is the most powerful comedy.
This view got its rude awakening starting at the end of that year. Proponents did not understand that the economy works very differently at 30% public debt/GDP compared to 100% debt/GDP. Somewhere between those two levels, higher rates become a stimulating force, not a contractionary one.
Most believed that the 1H22 recession was part of a larger economic downturn. But then GDP started reaccelerating fueled by the fiscal impulse taking off again. I don’t think there are many people left in this camp today.
Thirdly, you may be bullish stocks with the expectation that rates will fall. I call this the Return of the QE age which is reminiscent of how the US economy worked in the 2010s. It works based on the assumption that low rates are stimulating because they encourage consumption and investment. I believe the camp favoring scenario is quite strong and growing. Rate cuts are expected to revive the economy should risks materialize. I believe this is very misguided as I have articulated quite often over the last months.
Lastly, what’s left is to be bearish stocks with the expectation of falling rates. I believe this is far out of consensus view right now. Ask anyone where they see the S&P 500 if rates drop to 3% by the end of the year. Most will tell you 6,000+.
Believing the opposite is basically GFC doomerism. Given the phenomenal stock market performance after the GFC, this GFC doomerism is in my opinion a very easy way to get ridiculed. That raises the odds that it may actually be on point.
Sincerely,
Rene