I’ve invented a term called the “Threshyield”.
It’s really cool and important but sadly can’t be calculated or even spotted until after the event.
But it’s nonetheless an important concept to get your head around.
It is the yield at which market participants get a shiver down their spine.
The yield on government bonds that is.
Allow me to illustrate what I mean.
Equity markets have benefitted greatly from very low interest rates as measured by the very low yields on government bonds.
That’s for a number of reasons, such as the lower discount rate which can be applied to future earnings, and a lower equity risk premium (the return you’ll accept for the added risk of choosing equities over supposedly “risk-free” bonds).
If the expected returns of bonds are low, say 0.5%, then equity prices can go higher, because expected returns on equities fall when prices are higher, bringing equities and bonds back into balance.
Low interest rates also encourage and allow borrowing and speculation, because it is cheap to do so.
So interest rates falling increases the debt of companies and the leverage of investors.
If rates rise again, then there is a point at which companies start struggling to pay the interest on their debts, and leveraged investors start worrying about that, and about the low expected returns.
This impacts equity markets indirectly and directly, by worsening the balance sheets of the companies themselves, and by changing the dynamics of equity preference among investors.
That’s why rates have risen into each of the last four major equity market corrections – 1974, 1990, 2000 and 2008.
There comes a point at which the debt burden becomes unsustainable to a country’s companies (and government).
This point is what I am calling the “Threshyield”.
When the Threshyield is reached, businesses across the country, across the world, start struggling under the burden of their debts. And because rates were lower a while back, their debts have increased.
When the Threshyield is reached, equity investors panic because they need to frantically recalculate the present value of future cash flows with a much higher discount rate. And they need to rethink whether the risk of high valuations is tolerable when you can get a decent income from bonds.
An investor who could know at what point bond yields would spark this realisation would be very powerful indeed.
I started researching this because I saw the 3% figure being bandied about, but it didn’t sit right with me.
“The last time rates hit 3% that’s when the equity market started struggling, so that’s the number we should be wary of.”
That’s oddly simplistic I thought.
Because the debt pile has grown each time, and so surely the point at which yields start causing concern must come down.
You could afford to pay 10% on a hundred quid loan.
But 10% on ten grand? That’s less fun.
So I started looking at the last four major crashes – 1974, 1990, 2000 and 2008.
You see, in the US, the total public debt grew between each, and so the point at which yields because unbearable fell.
I have highlighted in yellow the yield on the US government ten-year bond which was reached as the S&P began its big declines. Those are the past four Threshyields. Can they help us calculate the next one?
(Data source: FRED economic data)
I can present that slightly better I’m sure, but let me use words rather than numbers, if that helps.
The total public debt of the US was just $473 billion in 1974, up from $414 billion.
While total public debt grew in that time, the ten-year government bond yield also rose, from 5.88% to 6.98%.
That means that the annual interest rate burden on all public debt in the US grew from $24.2 billion to $33.0 billion.
That’s a 36% increase in the interest rate burden in just over two years (October 1971 to January 1974).
In 1974, the stock market (S&P 500) fell by about 50%, peak to trough.
The same pattern can be seen leading up to 1990, 2000, 2008 and 2021. Those years saw stock market drawdowns of 21%, 51%, and 57% respectively.
Between 2008 and today, total public debt in the US has grown extraordinarily, especially in the least 12 months.
The interest burden more than doubled from $212 billion in mid-2003, to $483 billion.
Since 4 August 2020, the interest burden of all public debt in the US has almost tripled from $140 billion to $417 billion.
What can we say about this?
If equity markets found 5% too much to bear when total public debt was under $10 trillion, it’s no wonder that the Threshyield is much lower now that the mountain of debt is $27 trillion high.
As debts grow, they become less tolerant of high interest rates.
This can be adjusted for GDP, as GDP also grew in the intervening periods.
Perhaps what matters is the size of the debt in proportion to GDP.
Adjusting for GDP…
The interest burden grew from 2.06% to 2.22% in 1974.
From 4.04% to 4.67% in 1990.
From 2.54% to 3.66% in 2000.
And from 1.88% to 3.33% in 2008.
Larger GDP matters because it means a greater ability to pay down debt.
But even accounting for GDP growth in the period leading up to stock market crashes, the growth of the interest burden matters. It matters for all the reasons we’ve discussed. It means companies have to spend money on paying interest rather than a new machine.
Since August 2020, interest rates have risen sharply.
This has led to a growth in the interest burden as a % of GDP from 0.72% to 2.10%.
That is the tripling from $140 billion to $417 billion I mentioned above.
In 2020, the US spent “only” $380 billion on the Navy and the Air Force combined.
This is why debt-to-GDP stats matter.
Once it goes over 100%, the effect of every slight move in the interest rate is multiplied in terms of the ability of GDP to cover that expense.
This has happened to many governments in the past – especially after wars.
Here in the UK, our debt was only about 35% of GDP before 2008. It rose to around 80% until now, and has just jumped to 110%, the highest level since, you guessed it, just after WW2.
When debt rises past 100% of GDP, stark choices are faced.
You can cancel the debt, you can renegotiate it, or you can devalue the currency in which the debt is owed.
To politicians and peoples alike, the third option is the most palatable and painless in the immediate future.
But in the meantime, think about the Threshyield when watching bond markets these days.
It’s tested tech at 1.5% on the US ten-year government bond. That’s just the tip of the iceberg though.
When does the Titanic hit?
At the incredibly important and depressingly unknowable Threshyield.
Wishing you all the best.
Editor, UK Uncensored