How do interest rates affect equity valuations?
While not at the center of day-to-day discussions about the markets, the risk-free rate is an important concept underpinning investing decisions and market valuations. It’s the theoretical rate of return for an investment with zero risk, creating an effective starting point for market analysis and evaluating the pricing for all other investments. Short-term treasury yields are the most common proxy for the risk-free rate. As those yields fluctuate, the pricing of risk assets is expected to adjust as well to varying degrees.
Short-term treasury yields don’t tell the full story though. Historically, there’s been a strong inverse relationship between longer-term yields and equity market valuations. As shown in the chart above, a rising 10-year Treasury yield has tended to correspond with lower P/E multiple for the S&P 500. The reverse has also been true, as illustrated most recently in 2020 as the yield on the 10-year Treasury fell well below 1% and the P/E multiple on the S&P 500 surged.
The opposite has also been true since the start of 2022, as short-term rates have risen by about 3.5%, which is a considerable move in a relatively brief period. In fact, yields are at levels not seen in nearly two decades, as noted in our associated piece. Recently, there has been a disconnect in the relationship between the risk-free rate and P/E multiples, a divergence that’s likely to dissipate over time. Whether that comes via a reversal in interest rates, a reduction in stock market multiples, or a combination thereof remains to be seen.
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