Ok so as you think about yields and equities and what to expect going forward as stocks decide whether they want to view Treasury rallies as risk-off triggers (i.e. as evidence that the reflation meme is drying up) or whether, should 1oY yields reprice rapidly higher, stocks want to view Treasury selloffs as risk-off triggers (i.e. tantrum-like behavior), you may want to consider some new commentary out Wednesday from BofAML.
As the bank’s rates team notes, there are two distinct regimes characterized by two different interpretations with regard to expectations for the short-end. In the era of dovish forward guidance, the market was effectively forced to express risk-off sentiment in the long-end. So, bull flattening. Now, with the Fed back in play, the argument for bull steepeners during risk-off periods would appear to be compelling again. Or maybe not.
Read the following and think about what it means now that we can no longer assume additional rate hikes are at least 12 months away.
The old normal vs. new normal
To look at the relationship between the curve and equities, we separate equity down days from up days and separately compare the impact on the 5s-30s curve. Chart 1 shows cumulative changes in the 5s-30s curve on days when the S&P500 is up vs. down.
2000- 2011: Notwithstanding recent memory, historically the US 5s-30s curve has bull steepened in response to a risk-off shock. This is very evident in the blue line between 2000-2004 and 2007-2011. The market’s response to lower equities would be to price in a more cautious Fed, helping support the belly (5y) of the rates curve and bull steepen the 5s-30s curve.
2011-2014: One of the largest changes in the US curve behavior was a result of the Fed’s forward guidance in 2011 (Chart 2). As the market priced out any possible hikes to beyond 12m (inactive Fed), risk-off episodes were clearly bull flatteners: the market’s only choice with little Fed action to price out, was to reduce term premium. This relationship is formalized when we run a structural break regression of the SPX on the curve, which shows an appropriate sign flip when the first hike moves beyond 12m.
Despite Fed pricing, curve could bull flatten
Given that, we are now in an “active” Fed environment, with the market pricing in multiple Fed hikes over the coming 2 years, the above precedent would clearly argue for bull steepening in response to risk-off. Yet we are cautious for two reasons
The break during a hiking cycle: While zooming in on the hiking cycle from June 04- June 06 (Chart 3), the active Fed vs. curve relationship broke. The curve bear flattened when equities went up and bull flattened when equities went lower. The price action over the last two days makes us wary of a similar move.
Large risk off: Second, while all of the above focuses on cumulating daily moves, even while isolating large risk-off moves, the evidence during a hiking cycle is mixed. There were six 5% equity corrections between 2004 and 2006 – 3 of them saw 5-30s bull steepen while the remaining 3 saw it bull flatten (Table 1).