One thing you might have noticed over the past two weeks or so, is that the narrative around what rising rates mean for risk assets has shifted materially.
There for a while, higher yields were viewed through the lens of reflationary euphoria and that was seen as a boon for risk. Rate increases were viewed as synonymous with a benign outlook for growth (especially in the context of Trump’s policy agenda in the US) and as such, the stock-bond return correlation was squarely negative: bonds sold off, stocks rallied.
The regime in the US shifted in the new year as doubts about the viability of the Trump agenda surfaced and questions about the extent to which the White House could get out of its own way pushed yields lower, drove the curve flatter, and took a toll on the dollar.
Still, risk rallied, thanks in no small part to voracious asset buying by global central banks whose purchases rose ~12% during H1, helping to perpetuate the vol. seller’s/carry trader’s paradise in which we’re all forced to trade.
After last week’s hawkish procession in Sintra, there are concerns that central banks are determined to combat excessively easy financial conditions by leaning against the wind no matter how weak the incoming inflation data is. The following chart from BofAML shows why that could be a problem for markets:
As Goldman put it earlier this week, “rates are currently part of the risk to equities rather than the support.”
And so, the question is whether the hawkish lean will break the Goldilocks environment characterized by solid (but not too solid) growth, tepid inflation (just tepid enough to keep central banks from getting too aggressive), and subdued vol.
Here with more on that is Nomura…
Goldilocks Markets Could End in These Three Ways, Nomura
An inflation jump, a term premium increase or a change in central bank reaction functions could each result in higher interest rates that would rock markets, according to Kevin Gaynor, head of international research at Nomura.
- If a non-growth related rate rise is sufficiently violent it could cause persistent shock to asset values, he says in note
- This would undermine business confidence and hit levered balance sheets, with potential knock-on to growth
- Question as advanced economies transition into positive output territory is whether there’s reason to believe cycle will be interrupted, or whether full cycle should be the central case
- Markets have been pricing in a Goldilocks scenario: benign growth, low inflation and slow central banks and therefore high valuations and low implied volatility
- Yet while returns have reflected this view, volumes are light and few investors appear to be willing bulls
- On possibility of a growth slump, he says: “Are there any indications from leading indicators of an imminent meaningful slowdown? The short answer is probably not”