A 4.8 Percent Treasury Is a Stock Trading at 20 Times Earnings With No Risk

What Happened Wednesday

The yield on the ten year Treasury note touched 4.818 percent today, a level it has not reached since November 2023. Then it backed off, and the stock market threw a small party about it.

The S and P 500 rose 0.46 percent to close at 7,666.60. The Dow gained 295.07 points, or 0.56 percent, to 53,061.95. The financial press described the move as yields taking a breather from the run up that carried them to multiyear highs.

A breather is an accurate description of the day and a misleading description of the situation. Yesterday the ten year rose three basis points to 4.7880 percent, which was itself a twenty month high. Today it printed higher still before easing. The direction has not changed. What changed is that it stopped for an afternoon.

The more useful question is not why yields paused. It is what a ten year Treasury yielding almost 4.8 percent does to the price of everything else, because that is the number every other asset now has to beat.

Where the Yield Came From

Nothing about this level is an accident. Three forces have been pushing in the same direction.

The first is the Federal Reserve. Chair Kevin Warsh said Friday at Jackson Hole that he would be hard pressed to describe financial conditions as restrictive, and that inflation running at 3.7 percent over twelve months and 4.1 percent over six is not improving underneath. Futures markets now put the odds of a rate hike at the September 16 meeting above a coin flip. The two year note, which tracks policy expectations most directly, jumped to 4.298 percent on the day of that speech.

The second is supply. The government issues bonds to fund its deficit, and the quantity of new paper the market must absorb each month sets a floor under yields regardless of what the Fed does. This is the force that has been pushing the long end, and it is why the thirty year yield reached 5.34 percent earlier in August with selling that came from overseas as much as from domestic accounts.

The third is inflation itself. A lender who expects prices to rise 3.7 percent a year demands compensation above that or loses purchasing power by lending. At 4.8 percent, the ten year offers roughly 1.1 percentage points above current headline inflation. That is not a generous real return. It is barely a normal one.

The Inverse That Confuses Everyone First

Bond prices and bond yields move in opposite directions. This is the single most important mechanical fact in fixed income and it trips up nearly everyone the first time.

A bond is a fixed set of future payments. A ten year Treasury issued with a 4 percent coupon pays 40 dollars a year on a 1,000 dollar face value, then returns the 1,000 dollars at maturity. Those payments never change. They are printed on the contract.

The only thing that can change is what someone will pay you for that contract today.

If new bonds start being issued at 4.8 percent, nobody will pay 1,000 dollars for your bond that pays 40 dollars a year, because for the same money they could buy a new one paying 48 dollars a year. So the price of your bond falls until the fixed payments, measured against the lower price, produce a return competitive with 4.8 percent.

The yield went up. The price went down. They are the same event described from two directions.

What a Yield Actually Is When You Own the Bond

Here is where people lose money by misunderstanding a word.

If you buy the ten year today at 4.818 percent and hold it for ten years, you earn 4.818 percent annually. That is contractual. The United States government pays it. Barring a default that would make the return on your bond the least of anyone's problems, that outcome is certain.

If you buy it today and sell it in eight months, you earn whatever the market will pay you then, which could be more or considerably less. The yield to maturity is a promise about the full holding period, not a prediction about next quarter.

Institutions treat these as two completely different products. A pension fund matching a known future obligation buys the bond for the contractual yield and does not care what happens in between, because it never intends to sell. A hedge fund trading the same bond cares about nothing except the path, because it intends to sell.

Both own the identical security. They are not making the same bet.

Duration, or Why 0.8 Percentage Points Cost 6 Percent

Duration measures how much a bond's price moves when yields move. For a rough approximation, multiply the change in yield by the bond's duration to get the percentage change in price, in the opposite direction.

A ten year Treasury has a duration of roughly eight. So a move of 0.8 percentage points in yield, which is roughly what has happened over recent months, implies a price decline in the neighborhood of 6 percent.

Six percent does not sound dramatic. Apply it to the wrong balance sheet and it is.

A bank that bought ten year Treasuries at 4 percent and holds them at 4.8 percent is carrying an unrealized loss of about 6 percent on that position. If the bank intends to hold to maturity, it collects its 4 percent and the loss never materializes. If the bank is forced to sell, because depositors want their money and the bank needs cash, the loss becomes real all at once.

This is exactly the mechanism that has broken banks before, and it is why the level of the ten year is not merely an interest rate story. It is a solvency input for every institution holding long dated fixed income.

Duration also explains why the thirty year moves so much more violently than the ten. A thirty year bond has a duration closer to seventeen or eighteen. The same 0.8 percentage point move costs it roughly twice as much price.

A 4.8 Percent Yield Is a 20.8 Times Earnings Multiple

Now the part that connects the bond market to the stock market, which is where most investors actually live.

Flip a yield upside down and you get a multiple. A bond yielding 4.8 percent returns 4.8 cents per year for every dollar invested. One divided by 0.048 is 20.83. So a 4.8 percent Treasury is mathematically equivalent to buying a stream of earnings at 20.8 times its annual amount.

Except this stream is contractual, guaranteed by the federal government, and requires no management team to execute anything.

That is the competition. Every equity in the market is now being asked why an investor should pay more than 20.8 times earnings for a business whose earnings might fall, whose management might make mistakes, and whose industry might be disrupted, when a risk free instrument is available at that price.

The Equity Risk Premium and Why It Can Go Negative

The formal version of that comparison is the equity risk premium. Take the earnings yield of the stock market, meaning annual earnings divided by price, and subtract the risk free yield. What remains is the extra compensation investors receive for taking equity risk.

Historically that premium has been positive, often meaningfully so, because stocks are risky and bonds are not, and risk demands payment.

The arithmetic gets uncomfortable when the risk free rate climbs. If the market's earnings yield is below 4.8 percent, which happens whenever the index trades above roughly 20.8 times earnings, then the equity risk premium is negative. Investors are accepting less current earnings power from stocks than they could get contractually from the government, and doing it in exchange for the possibility of growth.

That is not automatically irrational. Earnings grow and coupons do not. A business compounding its profits at eight percent a year is worth paying up for in a way that a fixed 48 dollar payment is not.

But it does mean the equity market is running on a growth assumption rather than on current value. When the discount rate goes up, that assumption has to work harder. This is the same mechanism that took the shine off small caps after Friday's speech, and it is why the divergence between the broad market and rate sensitive corners has been widening all summer.

The Term Premium Is Back, and That Is the Real Story

There is one more component inside a long term yield, and it is the one professionals argue about most.

Any long bond yield can be split conceptually into two pieces. The first is the average short term interest rate the market expects over the life of the bond. The second is the term premium, meaning the extra compensation investors demand purely for the inconvenience and risk of committing money for a long stretch rather than rolling over short term paper.

For most of the decade after the financial crisis, that term premium was compressed to almost nothing and at times was estimated to be negative. Investors were willing to lend for thirty years at barely more than they could earn rolling over short bills, partly because the Federal Reserve was buying enormous quantities of long dated bonds and partly because inflation seemed permanently dormant.

Both of those conditions have reversed. The Fed is no longer expanding its holdings, the Treasury is issuing heavily to fund the deficit, and inflation has proven it can return. A lender committing money for thirty years now demands to be paid for the possibility that inflation surprises again.

You can see it in the shape of the curve. The thirty year reached 5.34 percent in August while the ten year sits near 4.8 percent and the two year near 4.3 percent. Longer maturities yielding progressively more than shorter ones is a normal upward sloping curve, and after years of inversion it is worth noticing that normal has returned.

The consequence is that the long end is no longer purely a bet on Fed policy. It is a bet on whether the government can keep financing itself at these levels and whether inflation stays contained over decades. Those are much harder questions than what the committee does on September 16, and they do not resolve in an afternoon.

Why Stocks Rallied on a Day Yields Hit a High

Given all that, today's equity rally looks contradictory. Yields printed a twenty month high and stocks went up.

The resolution is that markets trade on changes, not levels. The relentless climb in yields since Jackson Hole had been the dominant pressure on equities for four sessions. When the ten year touched 4.818 percent and then eased rather than accelerating, the pressure stopped increasing.

Stocks did not rally because 4.8 percent is good news. They rallied because 4.9 percent did not arrive today.

That is a meaningful distinction for anyone reading market coverage. A relief rally is not a repricing. It is the absence of further damage, and it lasts precisely as long as the absence does.

Oil Is In This Story Too

There is a fourth force under these yields, and it sits in the commodity market.

Brent crude traded above 96 dollars a barrel this week after surging 9.3 percent the previous week. The driver is escalating tension around the Strait of Hormuz, the narrow waterway through which a large share of the world's seaborne oil moves, with the United States and Iran striking each other's military and commercial vessels and the American energy secretary saying the naval presence and blockade would be maintained.

Two things have kept the price from going higher. Major economies have been drawing down inventory, with the United States Strategic Petroleum Reserve falling below 290 million barrels, its lowest since 1982. And China has cut crude imports and reduced refinery runs.

Both of those are one time cushions rather than solutions. A reserve you have drawn to a forty four year low cannot be drawn much further, and demand that has been deferred tends to return.

Energy prices feed directly into headline inflation, headline inflation feeds into what lenders demand for tying up money for ten years, and that demand is the yield. The Strait of Hormuz and the ten year Treasury are connected by a chain of about four links.

The Bottom Line

The ten year Treasury touched 4.818 percent today, the highest since November 2023, and then eased enough for equities to gain half a percent. The easing is the news of the day. The level is the news of the year.

At 4.8 percent, the risk free rate is the equivalent of buying earnings at roughly 20.8 times, guaranteed, from an issuer that has never missed. Every stock, every building, every acquisition, and every business plan in the country is now competing with that number, and the three forces holding it up, which are a central bank leaning hawkish, a heavy calendar of government issuance, and oil near 96 dollars, are all still in place.

A pause is not a reversal. It is a pause.