Changes in short-term interest rates by the Fed have no effect on stock market P/Es on their own…unless the Fed fails to regulate inflation or avoid deflation.
Increases in short-term rates are meant to keep inflation, which drives P/Es and long-term interest rates, at a stable pace.
Short-term rate cuts, which are often used to boost the economy, must be achieved in a way that does not lead to inflation or encourage inflation expectations.
A yield curve spread of around 100 basis points (1 percent) implies that the long-term rate, which is linked to inflation expectations, will likely remain low.
Where the spread reaches 1%, there is a chance of higher inflation and lower P/E ratios.
Spreads below 1% indicate tighter monetary policy and attempts to manage inflation risks (although this also raises the risk of deflation and lower P/E ratios).
What is the reason for this? Short-term interest rates can only be marginally higher than the rate of inflation.
Short-term Treasuries could yield about 2.5 percent or less if inflation is held to the Fed’s goal of 2%.
Bond yields about 3% after accounting for the long-term spread of 1%.
And if we use the market’s forecast for potential inflation (which is currently about 2%), the long-term average will be less than 4%.
Furthermore, P/Es should remain in the low to mid 20s—except during market disruptions—but this is contingent on the inflation rate remaining low, indicating price stability.
Today’s yield spread 1 year Treasury = 0.05%, 20 year Treasury = 2.17%, Spread: 2.12%