Let me tell you something about the whole “when do higher yields start to weigh on equity prices?” debate: it’s a dead horse and everyone is going to continue to beat it mercilessly.
Over the weekend, we brought you multiple posts on this because you know, when everyone is standing around beating a dead animal it’s hard not to join the party. So far this week (and by “so far” I mean one U.S. trading day in), things seem to have stabilized somewhat, with 10Y yields kind of waffling around and Wall Street surging on Monday ahead of Jerome Powell’s testimony.
Where things go from here depends on a whole host of factors (and that’s a nebulous statement – I mean, when is it not true that the future depends on a whole host of factors?), but when it comes to the bonds/stocks debate, the waters are muddied not only by the unprecedented timing of Trump’s headlong plunge into the fiscal abyss and not only by Fed balance sheet rundown, which raises even more questions about who’s going to absorb all the new supply Steve Mnuchin needs to flood the market with in order to finance his boss’s pedal to the metal economy, but critically by the historically complicated relationship between bond yields and stocks.
You might recall that Goldman has variously described the especially fortuitous circumstances that have surrounded the longest bull market in 100 years for balanced portfolios. Not only have stock-bond return correlations been negative for the longest stretch in a century, but both bonds and stocks have also generally rallied. So you’re getting the best of both worlds: you get the diversification and simultaneous gains in both assets.
Needless to say, that’s kind of the crux of the whole yields-stock debate. At what point does the stock-bond return correlation flip decisively/sustainably positive, thus killing the balanced portfolio bull market and, almost by definition, imperiling risk parity in the process? Earlier this month we got a preview of that when 60/40 portfolios and risk parity took a hit as bonds and stocks sold off in unison. “Only five times since 1990 have simple risk parity and 60/40 balanced portfolios had weeks where they simultaneously sold off as much as they did – the last two times being during the global financial crisis,” Goldman wrote, in a post out during the week that preceded the short vol. blow up.
Well on Monday evening, Goldman was out with a new piece that takes a look at the history of stocks in rising yield environments and although this is, again, an exercise in dead horse beating, it’s worth highlighting a few key passages and charts.
Goldman begins by just coming out and stating the obvious, which is this: “What is clear is that the relationship is not clear.”
Yes, it’s “clear” that this is unclear. Have a look:
Next, Goldman notes that it matters where in the cycle we are when yields begin to rise.
“We find early-cycle rises in bond yields are accompanied by sharp rises in valuation, and that EPS is not the main driver of returns – indeed, EPS is often times still falling,” the bank writes, adding that “these are very different from mid- and later-cycle rises in bond yields, when there may be more worries about inflation, yields are starting from a higher point and equity valuations are already stretched.” Here’s a useful chart using the European experience:
Goldman goes on to reiterate what they and a lot of other folks have cautioned about since the bond selloff really accelerated late last month, which is that the rapidity of rate rise matters. Simply put, “if US 10-year yields increase by more than 2 standard deviations in a 3-month period, equities have [generally] sold off alongside bonds [as] when rates rise too quickly, they can weigh on growth expectations and valuations for risky assets and rate volatility can spill over to equity volatility.”
Next is a discussion about the balanced portfolio dynamics mentioned above and expounded in these pages on so many occasions that I couldn’t catalogue all of the posts if my life depended on it. Essentially, this just comes down to how equities are interpreting rising yields; that is, is rate rise a barometer of the robustness of the economic recovery or are rising yields saying something else that might not be as benign?
But here’s the key point: in the post-crisis era, it is likely that the “pain threshold” (so to speak) beyond which equities can no longer stomach rising yields has been reset lower. You can see evidence of this in a simple scatterplot.
“Reading from the historical scatter plots above, it looks as if bond yields at around 5% is when higher yields become a clear problem for equities – that is the point where the correlation with bond prices is no longer decisively negative,” Goldman writes, referencing the charts above, before delivering the important takeaway as follows:
Could it be earlier this time?Yes, we think this is likely. The more recent data points show the equity-bond correlation is now close to zero (see annotation in the charts).
And what about the real yields debate? This has been a special obsession for markets over the past week. After the Fed minutes, stocks began taking their cues exclusively from real yields (“exclusively” is obviously an exaggeration but hey, fuck it, right?). Here’s Goldman on that:
The relationship with real yields is not strong (over any time period) but it does tend to be slightly positive still. At the moment, the correlation has declined and is now around zero with real yields. We think this is reassuring, as higher real yields are not damaging for equities in general. Indeed, higher real yields are normally accompanied by higher real growth.
Of course there’s a breaking point on that too and that breaking point (i.e. the pain threshold for equities from real yields) is 2%. “We find that a real yield above 2% in the US (the current TIPS yield is 0.8%) would historically be associated with a negative relationship between real yields and equities – i.e., higher real yields at this point becomes damaging,” Goldman cautions. Here’s the chart:
If last week is any indication, real yields at 2% would be veritable catastrophe for equities, and that kind of underscores the worry with all of this tedious analysis (and I don’t mean Goldman’s take specifically, I just mean the entire body of recent work from analysts on this subject). It is by no means clear that history is going to be a reliable guide here.
Whatever the case, the bottom line appears to be precisely what Goldman says at the outset. Again:
What is clear is that the relationship is not clear.