I'm sure you've probably noticed this if you've been paying attention to any of the mainstream financial news media outlets, but people have developed a rather unhealthy fixation recently with trying to determine what the tipping point is on 10Y yields beyond which equities can no longer stomach rising rates.
It might seem strange that I would describe this as an "unhealthy" fixation given that I was most assuredly fixated on it earlier this month. In fact, if you recall, I wrote a string of posts on it for this platform, beginning with the rather prescient "Hey Guys? The Bond Selloff Needs To Stop, Like Right Now" on January 29 and culminating in a barrage of Saturday and Sunday posts a week later as it became apparent (to me anyway) that the bottom was likely to fall out starting the following Monday. All of those posts touched on the rise in 10Y yields and the likely knock-on effect for equities.
And while I did note the possible psychological effects of 10s at 3%, I was pretty adamant about it being the rapidity of the yield increase that mattered because it was the acceleration of the bond selloff that suggested the narrative was changing around higher yields. It's the narrative that matters here or, put simply: what are higher yields "saying?" Are they saying something about the robustness of the economy or are they signaling something about inflation fears, jitters about the relative wisdom of piling expansionary fiscal policy atop an economy that's already running hot, and the possibility that foreign demand for U.S. debt will wane just as Treasury ramps up supply to finance fiscal stimulus?
This of course comes as the Fed looks to continue down the road to policy normalization and the more signs there are of a sustained uptick in price pressures, the more worried the market gets about the viability of the "gradualistic" approach (which has defined this tightening cycle) to the normalization process.
On Tuesday, Treasury flooded the market with supply. I previewed that here and for those interested, it went ok, all things considered. Here's a quick recap, excerpted from my Tuesday afternoon market wrap:
The supply deluge from Treasury came and went and although I’m not sure “without a hitch” is the best way to describe it, it was digested relatively well all things considered (and by “all things considered” I mean “considering” the lunatic fiscal path the administration has set America down). The three- and six-month sales were fine, but of course auction yields were the highest since 2008. The four-week sale saw the lowest bid-to-cover since 2008 and the bid-to-cover on the two-year sale was 2.72 versus 3.22 at the previous auction. Also, note (get it?) the yield on the 2-year sale: 2.255%. I mean, just think about that for a minute. “Way” back on Irma Friday (i.e. just before everyone thought Miami might become Atlantis within 48 hours) 10Y yields looked like they might fall below 2%.
That last bit is especially notable as it underscores just how far we've come over the last six months.
In any event, the overarching concern here is how quickly yields rise and also what's driving it. On the former point, don't forget this from Goldman, out earlier this month in the wake of one of the worst weeks for balanced 60/40 portfolios in decades:
As we have written before, the equity/bond correlation depends on the level, speed and source of bond yield moves. The recent rapid repricing of bond yields has been again difficult for equity to digest. Since the crisis, if US 10-year yields increase by more than 2 standard deviations in a 3 month period, equities have sold off alongside bonds. When rates rise too quickly, they can weigh on growth expectations and valuations for risky assets and rate vol can spill over to equity vol.
Again, if what you want to know is when equities start having trouble digesting rising yields (i.e. when the stock-bond return correlation flips positive), the answer lies at least partly in the rapidity of rate rise.
Additionally, the details matter. Although real rates might indeed be the most important thing to watch, inflation is in the driver's seat there too. Recall this quote from Deutsche Bank's Aleksandar Kocic which I've used a lot in the past several days:
What complicates things is that the behavior of real rates at this point is also a function of expected inflation: Higher inflation warrants a more hawkish Fed and therefore pricing in higher real rates. The reaction of stocks is a non-linear function of inflation - although risk assets might “like” higher inflation, this would remain true only up to a certain point.
Here again, this comes back to the Fed and how they interpret rising price pressures. This is why the average hourly earnings print that accompanied the January jobs report was such a big deal and why last week's CPI print became an obsession for markets.
We'll get the Fed minutes on Wednesday and also a 5-year auction. The former will be interesting to the extent market participants can derive something about the committee's outlook for inflation from minutes that are by definition stale and the latter will be yet another chance for everyone to gauge demand for U.S. debt at a time when Treasury really - really - needs demand to remain robust. Consider this chart and accompanying color from Goldman (more here):
The US also appears to be headed into uncharted territory—at least for US fiscal policy—regarding the relationship between interest expense and the debt level. As shown in Exhibit 11, interest expense considerably exceeded the current level during the late 1980s and early 1990s, though the debt level was moderate
>Circling back to the underlying question for investors who just want to know what the level is on 10Y yields when stocks get nervous, the answer is that there are no easy answers. As Morgan Stanley put it on Tuesday:
What level of rates matters for stocks? As strategists we feel almost contractually obliged to provide an answer. The truth is, we don't know.
But do note what else the bank said in the same note:
Real yields matter most. Because earnings are (arguably) boosted by higher inflation, the rise in rates above expected inflation (real yield) feels like the most powerful driver of relative attractiveness. In one of the more remarkable developments of the last five years, US 10-year real yields have been remarkably stable in a 0-80bp range, implying little change in long-run policy expectations. But recent moves do take us right to the top of this range. Given how supportive this range was for multiple expansion, we think the risks of a break support the argument of our US equity strategy team that multiple expansion is over, and earnings are now in the driver's seat.
Right. And see that gets right back to everything said above about real rates and about how they're now a function of inflation too given the expected sensitivity of the Fed to price pressures now that the administration is aggressively stimulating the economy at full employment.
For their part, Credit Suisse thinks it's not time to be concerned about this yet. Here's a chart from a note that's making the rounds this week along with some comments the analyst (Jonathan Golub - he's their U.S. equities guy) made when contacted by Bloomberg:
Everybody says that rising yields are bad, but if you put aside that preconception and look at the data, you see that it’s not the case. If rates rise from 3%, that’s a good thing. If yields rise from 4%, that’s a problem. If rates rise from 5%, that’s a bigger problem.
>Yeah, I mean I'm not sure that's very useful. Ultimately, Credit Suisse does note the obvious which is that eventually, if you keep stimulating the economy at full employment, you're going to get pressure on margins as cost pressures rise. Here's Goldman on that:
A tight labor market, rising minimum wages, and tax reform bonuses all suggest rising wage pressures in 2018. S&P 500 firms in many sectors have announced wage increases and/or one-time bonuses tied to tax reform. In addition to these voluntary increases, minimum wages are rising in 19 states in 2018. Rising wages contribute to our forecast that valuations and margins will both peak in 2018. Core PCE inflation will climb to 1.8% by yearend from 1.5%. Tightening Fed policy in response to accelerating inflation should prevent meaningful valuation expansion.
And that's likely to be intensified by the push to compel corporate management teams to share the wealth (figuratively and especially literally) at a time when a chart of corporate profits as a share of GDP plotted with labor's share as a percentage GDP looks like this:
I'm not sure how much further corporate America is going to be able to push the envelope on that.
In any event, there is no definitive answer if the question is: "what is the level on 10Y yields that I need to worry about as an equity investor?"
I think it's critical that you understand that, because there is a ton of commentary out there right now penned by folks who claim to know with some degree of specificity what that level is. As usual, the (somewhat painful) reality of this situation is that if you really want to understand it, you have to dig down and try to wrap your head around the dynamics at play and why this is an issue in the first place.
Hopefully, this piece was helpful in that regard.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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