‘The Truth Is, We Don’t Know’: What Is The Line In The Sand For Bond Yields?

Well, the debate around what the number is for 10Y yields has devolved into a veritable obsession for markets at this point.

Of course this is to a certain extent an exercise in futility. There is no “magic” number and it would certainly appear that it’s the rapidity of rate rise that matters and not so much any specific level.

There are plenty of people who would disagree with that assessment, but yields have been rising for months and months and it didn’t seem to become a problem until the narrative changed – i.e. when rising yields stopped being interpreted by the market as a sign of the robustness of the economy and began to be seen them as something that could cause the Fed to lean decisively more hawkish going forward in the face of growing inflation pressure. Recall the following from Goldman:

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, it’s the rapidity that would appear to matter for the stock-bond return correlation or, more simply, for equities’ ability/willingness to digest the bond selloff.

The debate about yields is in focus again on Wednesday ahead of the Fed minutes, which will of course be parsed relentlessly for clues that, if they exist at all, will be magnified in traders’ minds and will almost invariably be used to support the prevailing narrative about the Fed’s more “constructive” take on inflation (where “constructive” means they’re starting to view the build in price pressures as some semblance of sustainable).

For their part, Morgan Stanley feels “contractually obliged to provide an answer” to your question about what level of rates matter for stocks and God bless them, they were honest enough to say this: “The truth is, we don’t know.”

But what they do “know” are the following three possibly useful things, presented here without further comment because God knows we’ll end up having to comment on this more later today:

1. 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.

2. …and are close to breaking their five-year range: 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 Michael Wilson and our US equity strategy team that multiple expansion is over,and earnings are now in the driver’s seat.

3. This issue is very different outside the US: This debate looks very different in other markets, where ERPs are still above long-run averages (Exhibit 5).From a long-run, structural return perspective, we think this will add to the appeal of non-US equities. Our top global market here is Europe.