Yields. Nominal ones. And also real ones. And inflation. And Fed hikes.
“Lions, tigers, and bears, oh my!”
Admit it, that’s all you wanna talk about. It’s all anyone wants to talk about. Because if we get to 3% on 10s, the ICBMs automatically launch. Next come the mega-cats (don’t worry, Berkshire will be fine). Swarms of locusts will descend on the crops. Famine will ensue.
3% on 10s… pic.twitter.com/NdvmnRt75V
— Walter White (@heisenbergrpt) February 25, 2018
No, but seriously the “what do rising yields mean for [fill in whatever you want]?” debate has devolved into the absurd.
I mean at a certain level, it’s all that matters right now. As noted earlier on Sunday, the circumstances here are unique to say the least. The U.S. is headed into uncharted waters in terms of fiscal policy at a time when the Fed is letting the balance sheet rundown. There are pressing questions about the durability of demand for U.S. debt from abroad. The reserve diversification discussion is heating up. And as Deutsche Bank recently noted, increased Treasury supply has second-order effects for foreign appetite.
Meanwhile, the Fed is looking to replenish its ammo by squeezing in as many hikes as they can, albeit at a pace that’s predictable. The problem: thanks in no small part to ill-timed fiscal stimulus and what that might mean for price pressures when it’s piled atop an economy that’s already operating at full employment, they’re now facing the possibility of being forced to hike faster than the market anticipates, and that’s helping fuel rate rise.
Clearly, all of this has implications for equities and for credit and because there are so many epochal shifts taking place, “what do rising yields mean for [fill in the blank]?” has understandably dominated the discussion of late.
That said, the obsession has probably gotten out of hand. People have begun to assign disastrous consequences to largely arbitrary levels on 10Y yields (of course they’ll say the levels aren’t arbitrary, but remember, someone who is OCD will tell you there’s nothing arbitrary about the imagined connection between washing your hands for the fifth time in 30 minutes and the odds of getting brain cancer).
The other issue here is that because some of the circumstances are unprecedented, history isn’t necessarily a reliable guide – that’s what “unprecedented” means.
Still, some folks think it might be useful to take a look back and see what history says about everything mentioned above. Some of what you’ll read/see below may come across as counterintuitive and rather than weigh in on that, I’ll just present it and let you draw your own conclusions. The first set of charts and accompanying color is from Deutsche Bank and the second, from Goldman.
Via Deutsche Bank
Is inflation bad for margins and earnings? Historically, higher inflation has been associated with higher margins and strong earnings growth.
The correlation between bond yields and equities depends on the driver: inflation (-) or real rates (+). Contrary to popular notions that higher bond yields mean lower equities, the historical relationship between bond yields and equities has been ambiguous. Instead, the impact of higher yields on equities depends on whether they reflect higher inflation (-) which has always been negative for equities; or whether higher yields reflect higher real rates (+) which have always been positive for equities until real rates reached very high levels (greater than 4%–seen only once during the Volcker disinflation).
A 1pp rise in inflation compresses multiples by 1 point. A majority (70%) of the historical variation in the S&P 500 multiple is explained by its drivers: earnings/normalized levels (-); payouts (+); rates broken up into inflation (-) and real rates (+); and macro vol (-). Our estimates imply that a 1pp rise in inflation lowers the equity multiple by 1 point or a 5% decline in prices from the recent peak.
To get some historical perspective on the impact of higher rates on corporate bonds, we revisit IG and HY spread and total return performance during the last five rates bear markets: 1994, 1999, 2004, 2005, and 2013. Exhibits 3 and 4 put this performance into perspective and show cumulative spread change and total returns in the IG and HY markets during the above rates bear markets.
The message from Exhibits 3 and 4 is twofold. First, as we have discussed in recent research, spreads moved broadly tighter as rates were drifting higher. Second, after initially moving lower in response to lower price returns, total returns did stabilize in IG and rebounded in HY, as the combined effect of tighter spreads, roll-down, and carry eventually offset the damage from declining prices. Will the recent rates sell-off result in the same outcome for corporate bond total returns? Although negative convexity is much more pronounced today relative to historical norms, we think barring an unlikely scenario of a wider spreads/higher rates double whammy (driven by rising inflation fears for example), the carry offered by major corporate bond indices will likely increase over the course of the next few quarters as new bonds with higher coupons are included. At the same time, stable spreads and steep curves will allow investors to continue to benefit from some spread tightening as they roll down the curve. All in all, these three forces should mitigate the impact of the recent price declines and allow total returns to rebound.