The markets are frustrated, waiting for a decline in interest rates. There is now the added concern of rates going higher. In a recent note, I showed that when credit risk is tight, as it is now, FCF yield (Free Cash Flow per share divided by current share price) moves in tandem with the direction of interest rates. The reason is that the cash flow duration is shorter for value companies than for growth companies. Hence, increasing rates benefit value, and declining rates hurt. The FCF yield factor for value stocks that I use is a long-short portfolio of stocks from the top 500 market cap US stocks, long the top FCF yield stocks, and short the lowest in each sector (i.e., sector neutral). It is produced and rebalanced weekly using Finsera platform.

A key takeaway from my previous note was that value stocks would outperform as rates climb and tend to lose as rates fall. The chart here clearly illustrates the covariation between interest rates and FCF yield.

You could also use the tendency of interest rates and value stocks to move in the same direction to learn what value stocks tell you about the trajectory of interest rates. Using FCF yield, what are value stocks pricing about the direction of interest rates?

The green circle on the right highlights a notable feature in the chart. Despite rates climbing from mid-May 2023 until mid-October, then dropping until the end of 2023 (blue line), FCF yield return remained unaffected and continued to climb steadily (orange line). In other words, equities have been pricing rising rates all along. The sharp rise in rates from May 2023 through October was too rapid as far as FCF yield return was concerned. The fixed-income market corrected that. And now, FCF yield return continues to climb as rates rise in tandem. The concern about rates going higher looks reasonable. Corporate cash flows may be signaling higher rates.

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