What is the Yield Gap
The yield gap is the difference between the earning yields and the government bonds yield (Normally, it will be a 10-years U.S. Treasury yield). The yield gap trend reflects how stocks are performing compared to the government bonds yield which is a risk-free investment, this will help the investors decide where to allocate their investment.
The higher yield gap reflects the larger gap between the earnings yield and the government bonds yield. Conversely, the lower yield gap reflects the smaller gap between the earnings yield and the government bonds yield.
Investors tend to invest in the stock market during the large yield gap trend and tend to invest in government bonds when the gap is small.
For your information, the yield gap is also known as: the earnings yield gap, yield gap ratio, yield ratio, and bond equity earnings yield ratio (BEER).
How to Calculate the Yield Gap
The yield gap can be calculated by dividing the earnings yield with the long-term Treasury bond yield (10-y Treasury yield).
Yield gap = Earnings yield ÷ Government bonds yield
Note: You can follow the 10 year U.S. Treasury yield on U.S. Department of Treasury website.
For example, the U.S. stock market yield is 2.5%, while 10 years Treasury yield is 1.5%. The earnings yield will be 2.5 ÷ 1.5 = 1.6%.
What does the Yield Gap Indicates?
Normally, an investor uses the yield gap to determine which investment is more attractive, between stocks and government bonds (risk investment vs safe investment).
A large number of the yield gap (Earnings yield > Treasury bonds yield) means the difference between the stock market and government bonds is large. In other words, the stocks are cheap or underpriced.
During the large yield gap trend, investors tend to allocate their investment to stocks (or related risky investments) to find more yield.
A small number of the yield gap (Earnings yield < Treasury bonds yield) means the difference between the stock market and government bonds is small. In other words, there is no difference between investing in the stocks market and the bonds market, while the stock is higher risk than the bonds.
During the small gap trend, investors tend to allocate their investment from risky investment into lower risk and risk-free investments like government bonds.