Transmission to Markets: Real Rates, Term Premium, Equity Multiples, Credit Spreads, Currencies and the 12–18-Month Lag

What you will learn

• How to split a long-term yield into expected short rates and term premium.
• How a change in the real yield moves equity multiples through the earnings-yield identity.
• How credit spreads and exchange rates respond, and which reacts first.
• Why the effect on the real economy and inflation arrives with a lag of roughly 12 to 18 months.

Explanation

Three layers inside a 10-year yield

A central bank controls only the overnight rate; everything else is transmission. A 10-year yield decomposes as:

10-year nominal yield = average expected short rate over 10 years + term premium

The term premium is the extra return investors demand for holding a long bond instead of rolling short bills. It is not observable; models such as the New York Fed's ACM estimates infer it and disagree by tens of basis points. Policy rates move the first component; asset purchases mainly move the second (lesson 3).

The nominal yield can also be split into a real yield plus break-even inflation (covered in Bonds in Depth, lesson 7). For asset prices the real yield is the one that matters: it is the risk-free alternative measured in purchasing power.

Equity multiples: the earnings-yield identity

The earnings yield is earnings divided by price, the inverse of the price-to-earnings ratio (P/E). A simple identity:

earnings yield ≈ real yield + equity risk premium (ERP)

The ERP is the extra return required for holding shares. If it stays constant and the real yield rises, the earnings yield must rise and the P/E must fall. The effect is larger for "long-duration" growth stocks, whose earnings lie far in the future, which is why they can fall while profits are still growing.

Credit spreads and currencies

Corporate borrowing costs are the government yield plus a credit spread. The risk-free yield rises first; spreads widen later, as refinancing gets harder and defaults rise. Spread changes hurt prices through spread duration, as in lesson 7.

Exchange rates react within seconds, because capital moves instantly to the better expected real return. The two-year yield differential is the most-watched gauge; forwards already contain it (lesson 8).

The lag

Milton Friedman described monetary policy as working with "long and variable lags". The order is roughly: money-market and currency moves on the day; bond yields and equity multiples within days; bank lending rates for new loans within one to three months; housing activity and corporate investment after six to twelve months; employment and inflation after twelve to twenty-four months. This is why a central bank that waits for inflation to reach 2% before stopping hikes will usually overshoot. Economists disagree on whether fixed-rate mortgages have lengthened the lag; treat 12 to 18 months as a rule of thumb.

Worked example

Hypothetical example: an equity index trades at a P/E of 20.0. The 10-year real yield is 1.0% and the equity risk premium is 4.0%. Earnings are assumed constant; dividends, taxes and costs are ignored. All numbers are invented round figures.

Step 1 – check the identity: earnings yield = 1 ÷ 20.0 = 5.0% = 1.0% real yield + 4.0% ERP. Consistent.

Step 2 – the central bank signals a higher path and real yields rise by one percentage point to 2.0%. New earnings yield = 2.0% + 4.0% = 6.0%.

Step 3 – new P/E = 1 ÷ 0.06 = 16.7.

Step 4 – price change at constant earnings = 16.7 ÷ 20.0 − 1 = −16.7%. A €10,000 index holding would be worth about €8,330.

Step 5 – credit leg: an investment-grade bond fund with spread duration 6.0 sees spreads widen 50 basis points: 6.0 × 0.50% = −3.0%, before any effect from the risk-free yield itself.

Step 6 – the lag: the repricing is immediate, but the slowdown that justifies it may only appear in data a year later.

Common mistake

Practice activity

On paper: an index trades at P/E 16.7 with a real yield of 1.5% and an ERP of 4.5%. (a) Confirm the identity. (b) The real yield rises to 2.5%; calculate the new P/E and the percentage price change at constant earnings. (c) A fund of long-duration growth stocks has an effective ERP of 3.0% at the same real yield of 1.5%. Repeat the calculation and compare the sensitivity. (d) Name the market variable that reacts first and the economic variable that reacts last.

Key takeaways

• Long yields = expected short rates + term premium; real yields are the discount rate that matters for assets.
• Earnings yield ≈ real yield + ERP; a one-point rise in real yields cut a P/E of 20 to about 16.7 in the example.
• Currencies react first, credit spreads with a lag, and the real economy last.
• Use 12 to 18 months as the working lag; judge a policy by the data one year later, not by the first trading day.

Next step

Next, we learn to read what the market has already priced, using OIS curves and €STR and SOFR futures, and what "50 basis points of cuts" means in numbers.