What does the Fed model relate?

The Fed model establishes a relationship between the earnings yield of equities (typically represented as the inverse of the price-to-earnings ratio) and the yield on 10-year Treasury bonds. The underlying principle of this model is that both earnings yield and Treasury yield represent the opportunity cost of capital for investors, thus allowing for an assessment of whether stocks are overvalued or undervalued in relation to bonds. When the earnings yield is higher than the Treasury yield, equities may be considered undervalued compared to bonds, and vice versa.

This model is significant because it provides a simplified framework for comparing the expected return on stocks against the risk-free return provided by government bonds. As such, it helps investors make informed decisions about asset allocation between equities and fixed-income securities based on relative valuation.

In this context, understanding the correlation between earnings yield and 10-year treasury yields is essential for evaluating the appeal of equity investments relative to other fixed-income options.