Equity Risk Premium: Regime Change Accomplished

The US equity risk premium is basis points away from its pre-Global Financial Crisis mean, and at its narrowest in more than 15 years. It’s not because stocks are over-valued. Indeed, from pre-pandemic highs, they are up less than half the gain in forward earnings. The narrow ERP is driven by an historic bear market in bonds, more than twice as great as any historical precedent. So the narrow ERP does not imply that stocks should be sold, but rather that bonds should be bought. The 10-year yield is almost flat to the market-implied funds rate for the November FOMC, and inverted to the December FOMC. The two prior hiking cycles ended when the 10-year inverted to the funds rate, and Powell has cited that explicitly as a policy guidepost. He is likely to honor it, as inflation continues to show signs of having peaked. This is consistent with leaked reports that the November FOMC will hint at braking the hiking cycle.