Well, I guess this is as good a time as any to talk about yields – again.
Although most investors are undoubtedly aware, in hindsight, of the role rising Treasury yields played in setting the stage for the turmoil that rocked markets earlier this month and erased some $3 trillion in value, it’s not at all clear that everyone has a solid grasp why this suddenly became a problem.
After all, it’s not as if yields weren’t already rising. But it is readily apparent that a whole lot of market participants were not prepared for the sudden shift in the narrative around those rising yields. Indeed, it’s not at all clear that the vast majority of market participants understood what the original narrative was or that narratives even mattered in the first place.
You can tell a lot of people had no conception of that because some $40 billion was plowed into U.S. equity funds in January just as the bond rout was accelerating.
pour out a little of your 40 oz. for the people who poured $40 billion into U.S. equity funds last month. pic.twitter.com/mKmMygtMtG
— Walter White (@heisenbergrpt) February 8, 2018
That acceleration in the bond selloff led to some of the worst risk-adjusted returns for 10Y U.S. Treasurys on record and it was abundantly clear to those who understood the backdrop that the narrative was rapidly shifting and that the rapidity of rate rise was likely to flip the stock-bond return correlation positive in fairly short order.
Given anecdotal evidence that suggested at least some of the money that flooded into U.S. equities to start the year came courtesy of retail investors (E*Trade added 64,581 gross new brokerage accounts in January, the most for a single month since September of 2016, for instance), it wasn’t hard to predict that a lot of the $40 billion highlighted in the chart above would likely come pouring right back out at the first sign of trouble, which is exactly what ended up happening.
So circling back, what was it that most investors didn’t understand about the narrative around rising bond yields? Well, they didn’t understand that the reason equities were able to stomach rising yields right up until February was because rising yields were still seen as a sign of a robust recovery. Once that narrative changed, the stock-bond return correlation flipped, and the rout was on.
Now the question is how that narrative will evolve and what we can expect the reaction from stocks to be going forward. On Saturday we brought you the latest from Deutsche Bank’s Aleksandar Kocic, who wrote the following in a Friday note:
Locally, the main problem for risk assets is a rise in real rates: Having UST bonds with strong dollar or high real yields will be more attractive than holding US stocks, which means accelerated de-risking and higher volatility in the stock market. Higher inflation, on the other hand, would be supportive for equities and could cause another leg of selloff in bonds. 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.
There isn’t an easy way out of this for equities and when it comes to the “certain point” mentioned in that last bolded passage, the risk is a disorderly unwind of the bond trade, something more than a few high-profile names have warned about over the past six months. “Although negative convexity of inflation is a far OTM risk, it is significant even at remote distances from the strike, due to its enormous size,” Kocic wrote, in the same piece, adding that “the accumulation of relatively illiquid long-dated bonds on retail balance sheets is at toxic levels and a substantial rise in inflation, to which there is no adequate policy response, could threaten to trigger a bond unwind that the market would be unable to absorb.”
Playing out in the background here is reckless fiscal policy (“YOU WILL RIDE ETERNAL, TACKY AND GOLD LEAF”) which has the potential to supercharge inflation, bring forward the end of cycle and potentially force the Fed’s hand. Meanwhile, foreign demand is in question and there are multiple reasons to believe that as it wanes further, downward pressure on the term premium will disappear.
Given all of this, it’s worth noting that Goldman is out lifting their 10Y DM bond yield forecasts across the board (3.25% for US Treasuries, 1.0% for Bunds, 2.0% for Gilts and 10bp for JGBs). For Treasurys, the bank now projects 3.25% by year-end. In the note, they trace many of the story lines detailed above. To wit, on how the narrative panned out in the lead-up to February’s mini-tantrum:
The rise in bond yields has largely reflected stronger growth expectations. US bond yields have increased almost incessantly since last September. According to our estimates, this has mostly reflected a ‘genuine’ increase in expectations around the medium term trajectory for Fed policy rates, rather than investors’ increased demand of compensation for bearing duration risk. Such revisions in expectations around the path for Dollar short rates have, in turn, tracked the sequential upgrades to consensus forecasts for future US real GDP growth (Exhibit 1) and, to a lesser extent, CPI inflation (Exhibit 2). Responding to positive incoming news on economic activity, bond yields and stock prices have been rising in tandem.
And here is what changed:
More recently higher inflation uncertainty has resulted in a rebuild of term premium. During January, bond investors’ focus shifted from growth, to an acceleration of price and wage inflation and to the negative effects on long rates of larger net supply of government bonds. This led to a rebuild of ‘term premium’ along the Treasury curve (i.e., an increase in yields without an intervening change in rate expectations), from very depressed levels (Exhibits 3, and 4). More than the level of rates, it was the resulting steepening of the US yield curve and the increase in volatility that triggered the unravelling of illiquid investment strategies levered on relatively low and stable long term yields, weighing on broader risk sentiment.
There you go. And most investors had no conception of that dynamic whatsoever.
Goldman continues, noting that they continue to see “fundamental arguments in support of higher long-term yields, and a steeper curve than priced into the forwards, as the Fed tightens monetary policy further and macro uncertainty increases.”
Additionally, the bank weighs in on the collision of waning foreign demand and the end of cycle dynamic: “First, as the Fed pursues ‘quantitative tightening’, the ECB brings QE to an end, and the BoJ eventually re-pegs its 10-year yield target higher, the subsidy offered by central banks for holding duration risk will diminish [and] on historical relations, we find that US term premium should increase as the economy progressively overheats.”
So it’s ultimately up to you to draw your own conclusions about what this could mean for equities and to be clear, there’s no “easy” answer. But we’d be willing to bet that a whole lot more people care about this topic now than they did just three weeks ago.
Funny what losing $3 trillion will do.