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.
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