So here’s an interesting observation that may or may not approximate reality but is nevertheless an amusing exercise in dot-connecting: those of us who know a little something about markets and appreciate the extent to which post-election cross-asset price action has been driven by the reflation narrative have failed miserably when it comes to recognizing the extent to which a whole lot of equity investors know nothing.
More simply: those of us who know something have underestimated the extent to which equity investors know very little.
See we (the “know-somethings“) assumed that retail investors (the “know-nothings“) would appreciate the correlation between rising rates, a stronger dollar, and rising stocks. That is, we assumed retail understood that this market is narrative-driven.
But retail did not and does not understand that. Which is why we were wrong to assume that as yields fell and the dollar weakened on a dovish Fed and an increasingly indeterminate outlook for tax reform, stocks would fall too. Because retail didn’t understand the narrative, all the “dumb” money noticed was a dip and because that dumb money didn’t appreciate the fact that said dip was directly related to falling yields and a weaker dollar, that money simply bought said dip, lower yields and a weaker dollar be damned.
So now, the “know-nothings” have accidentally turned the tables on us “know-somethings.” If the narrative held, falling yields would beget lower stock prices as the narrative becomes increasingly questionable. Now, yields have bottomed in terms of how low they can go based on a cracking narrative (I mean the 10Y short is almost completely covered) and the only thing that can drive them lower is… wait for it… lower stock prices. The “know-nothings” now control the narrative and they don’t even “know” it. Lower yields will henceforth be contingent upon lower stocks.
Try to use that as a framework as you consider the following from BofAML.
Rates under a Trump unwind: at the mercy of the stock market
The bigger risk for rates under a Trump unwind would likely be the knock on implications of the stock market move. Arguably, equities have priced much more in terms of upside risks from expectations of policy stimulus relative to rates. To quantify this knock-on impact on rates we look at historical moves in term premium vs. significant equity market correction episodes. Specifically, we isolate SPX corrections >5% and look at the change in term premium in the 10y point of the curve (Chart 5). Empirically, a 5% correction has led to about a 15bp decline in term premium.
In conclusion, we would argue that from current levels, 1) rates still have significant room to re-price higher if the tax reform process speeds up. 2) If markets turn sour on the prospects of fiscal stimulus, the implication on rates will be limited to the knock on impact of equity markets on term premium.