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10Y dollar economy fed inflation S&P 500

There Is ‘Only One Scenario’ Where Equities Benefit From Here

Boy, I'll tell you what: I would absolutely love to rent out a small auditorium, pack it full of economists and analysts, make it an open bar event (so, all you can drink for free), set the conversation topic to "impact of rising rates on stocks", lock the all the doors and then watch what happens from the safe confines of an observation deck.

Boy, I’ll tell you what: I would absolutely love to rent out a small auditorium, pack it full of economists and analysts, make it an open bar event (so, all you can drink for free), set the conversation topic to “impact of rising rates on stocks”, lock the all the doors and then watch what happens from the safe confines of an observation deck.

Obviously, this is all anyone wants to talk about these days and it’s clear why. This month’s market turmoil was variously attributed to the above-consensus hourly earnings print that accompanied the January jobs report which, according to the narrative, is a sign that inflation pressures are building (wage growth being one of the missing pieces of the puzzle to this point). More importantly, this debate is taking place against a backdrop of reckless fiscal stimulus, piled atop an economy that’s already running at full employment and then to top things off, we’ve got a rookie Fed chair who, while not necessarily lacking on the credentials front, is by definition untested when it comes to steering the ship.

The ill-timed fiscal stimulus is the fly in the ointment here because it complicates the Fed’s decision calculus and also makes it difficult to decipher what the fuck the dollar is doing on any given day (why are people dumping it when rates are rising?, etc.).

 

The debate has shifted to real rates which appear to be in the driver’s seat for equities at this juncture. Again, this is complicated by the fiscal stimulus discussion (real rates moving higher as the U.S. budget deficit expands on the way to financing Trump’s foray into fiscal insanity) and questions about how the Fed will respond to the likely side effects of implementing expansionary fiscal policy when the economy is already running hot.

In short, this is impossible to tease out definitively. There’s too much going on and the entire effort is complicated immeasurably by the fact that because the post-crisis monetary policy response was unprecedented, we have no way of knowing how the market is likely to respond to the unwind of that policy and as it happens, the U.S. is at the forefront of that unwind with the Fed running down the balance sheet just as Treasury supply ramps up.

That’s the backdrop against which we bring you the following from Bloomberg’s Mark Cudmore out Friday.

Via Bloomberg 

Treasury yields are not in equilibrium at current levels. If they go higher, the dollar will rise and equities will fall. If they go lower, what happens to other assets will probably depend on what the catalyst for the move was.

  • This day last year, U.S. two-year yields closed at 1.18% and the 10-year was at 2.37%. At that time, consensus CPI forecasts for 2017 and 2018 stood at 2.4% and the 2019 projection was 2.2%
  • Since then the inflation outlook has dropped across the curve. It’s not just that 2017 inflation missed those expectations by 0.3 percentage points. More importantly, we now expect less inflation in 2018 and 2019 than we did a year ago, at 2.3% and 2.17% respectively
  • So the inflation outlook has deteriorated and yet two-year yields are more than 100 basis points higher, with the 10-year up more than 50bps. That’s an extraordinary rise in real yields. It was reflected by TIPs yields closing at the highest level in more than four years earlier this week
  • Ignoring whether Treasuries are sustainable at this level, one thing is certain: the climb in yields isn’t justified by inflation dynamics
  • Coming into February, tax reform, global growth, Trump impacts and fiscal deficits were all being used to explain how equities could continue to roar and the dollar slump even as real yields tightened. All those things have now had a chance to be fully priced in
  • Real yields now stand at a critical technical juncture. A break up and there’s nothing left to stop the dollar roaring and equities melting
  • What happens if yields go lower? If the move is led by a retreat in equities, then that’ll cause P&L-destruction that will also squeeze dollar shorts
  • If yields fall because there’s a technical failure at 3% that squeezes Treasury shorts or because investors give up on this idea of accelerating inflation, then expect equities to drop and the dollar to benefit from haven flows
  • The only scenario where equities benefit is one where real yields fall because inflation and growth get rapidly revised up. That would be bad for the dollar
  • But where is this sudden, massive boost to inflation and growth going to come from?
  • So summing it all up: the most likely outcome is a stronger dollar combined with lower equities. Controversially for some, this may be accompanied by lower yields as well
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6 comments on “There Is ‘Only One Scenario’ Where Equities Benefit From Here

  1. broblawsky

    Why would inflation expectations be revised down? We’ve seen nothing but upside surprises.

  2. “More importantly, this debate is taking place against a backdrop of reckless fiscal stimulus, piled atop an economy that’s already running at full employment and then to top things off”

    I equate it to being at waterhole around midnight and thinking, “I should have a couple more bourbons before hitting the road”. Regrettable choices

  3. BlueSkies123

    I suspect investors are worried about the massive tax cut driven fiscal stimulus and their impact on bond prices. Some think growth will jump to 4% and that will mitigate the deficit spending but that is an uncertain bet.

  4. HBensmiller

    Well, as I see it the Fed is most likely to remain in control of short term rates (continued low’ish inflation even with some creep) while longer term rates maintain an uneven climb in reaction to unwind + growing fiscal funding demands + increasing pressure from unsolvable deficits. US equities decline as economic cycle wanes and risk-on mentality builds. Any decrease in LT rates due to equity selling should be short lived… LT rates just have to trend up in reaction to debt supply / fiscal situation… pushing money market cash to short term debt or overseas markets. Oh if only I had a clear crystal ball….

  5. International markets are in control of the yield curve. As long as they stay away, like Japan has until maybe the Japan Insurance companies dipped back in last week, Treasury rates are going higher. The only way to satisfy the Trump-Treasury need for funds is by stocks sales if the Fed is going to cut off the domestic leverage spigot for more leverage domestically. On the international credit front, I don’t see the foreigners playing ball unless they can extract maximum pain, and Europe should be in retreat by Fall’18. It doesn’t have one iota of correlation to inflation. It is pure and simple power geopolitics telling Trump to take his trade plans to the garbage dump or else. Maybe the Fed will cut the need for reserves on excess reserves and the Money Center banks will soak up the need debt for a while and keep rates suppressed. But leverage and credit around the globe is just itching for a trigger to wind rates higher, and stocks lower.

    Those who can’t figure out that this is a dollar breaking scenario, not a dollar strengthening scenario obviously were not alive in 1971. It was lack of gold in US reserves at that time that caused a large scale dollar devaluation. and a folllow-on energy shock in 1973-74. Similar scenario is now in the making, only it is Trump, not Nixon that will do the devaluation to unwind 50 years of current account deficit madness. Let;s see who blinks first.

  6. Stimulus from here would create more treasury supply and more growth…higher inflation, and higher growth.

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