US 10 year risk free rate is the forward expectations (risk adjusted in terms of reaching that outcome) of a basket of NGDP expected. this is turn is determined by a starting rate of fed funds + real gdp t, t1,t2,t3.... until t40 assuming using 3 months fed funds. to start.
this indicates that given the odds the expected does end up as the realized (determined by vol appplied to Merton expansion of the t....t40 rates) will be 5% in 10 years semi annual over that to years. has been 6% in 2023 and as low as 4 1/2% recently. seems ot be settling 5%
think of the NGDP 10 year rate (1+NGDP)^40 then converted to semi annual. the difference between NGDP 2 year to NGDP 10 year is the curve between 10 year risk free semi annual and 2 year risk free.
the steeper the curve the more likely NGDP will grow or, via effect of compounding stay flat. the current yield curve shows that NGDP is expected to be 4 3/4% for the next 10 years.
this growth per year is the pricing of the term premium. right now the term premium is expanding indicating further economic growth is expected. it is a certainty that equity priced in the end to the corporate profits will grow at least at 4 1/2% but given leverage will be 1.5X
it is near impossible that equity markets, as long as these expectations for NGDP are being priced into one of the largest most liquid markets will not be that 6 3/4% to 9%.
currently the stock market - use S&P 500 - has been persuaded by first Fed Reserve 2022 on forward guidance and now by Trump's tariffs to trade at a large discount to that expected 6 3/4% to 9% expected NGDP growth.
right now, assuming corporate profits will trade at a very high correlation to NGDP, that Fed Reserve forward guidance that started in 2022, and then recently "Trump Fear" has made S&P 500 about 40% cheap to NGDP expected.
what would make the S&P 500 current levels justified is either Trump tariffs, the new budget, or sudden Fed Reserve tightening cause a deep recession that lingers of about negative 2% to 4%.
forward view is Trump tariffs do not adversely impact the economy , the Federal Reserve will not conduct a significant like Volcker79, new budget is not as the reconciliation which is not changed much from the Biden . major flows established by Biden will remain intact.
