Listen, you people are concerned about 10Y yields, and that’s fine. After all, we blew threw the February highs this week on the way to the “dreaded” 3% “pain threshold” and while there were no swarms of locusts and no Pazuzu sightings (that I’m aware of), there are still concerns that the higher we go, the closer we get to a situation characterized by “diversification desperation” or, more simply, a scenario where bonds and stocks selloff in tandem.
On Friday, the GDP beat was accompanied by more evidence that wage pressures are building stateside and that’s likely to further embolden the Fed and could, ultimately, contribute to higher long-end yields, especially if commodities prices continue to push breakevens higher.
One particularly disconcerting element to all of this is that it comes amid an apparent slowdown in growth, if not in the U.S. (yet), then certainly across the pond where the data has rolled over meaningfully (potentially changing the calculus for the ECB) and don’t forget about the U.K., where growth essentially flatlined in Q1 (leading to a sharp repricing of May BoE odds). And then there’s China, where Xi apparently believes more fiscal stimulus might be needed to offset the effect of the deleveraging push and any potential headwinds to growth from the ongoing trade spat with Trump.
To be sure, there are reasons to doubt the narrative that long end yields at current levels are sufficient to put undue pressure on equities. And although Goldman believes there are solid arguments for staying the course amid the rise in U.S. yields (more specifically, the bank thinks some of the pain in EM FX may be overdone) they also think this was “a more painful rate shock.” To explain why, they separate out recent market moves into three “broad phases”.
US long rates have moved up to 3% for the first time since the ‘taper tantrum’ in 2013 and late 2014. The nearly 60bp increase in rates in 2018 has occurred in two distinct bouts, with the surge over the past couple of weeks qualitatively different from rate moves earlier in the year, and with bigger ramifications in global asset markets.
It is helpful to divide the recent market moves in three broad phases (as in Exhibit 1). The first phase from December 2017 to early February 2018 had all the hallmarks of a classic ‘growth up, rates up’ environment. As current activity indicators moved higher across the world, rates moved higher in the US (by about 40bp) and the rest of G10, equities recorded stellar returns across all geographies, and the Dollar was soggy against both G10 and EM currencies. The second phase from February through mid-April encompassed both market and macro setbacks. A sharp correction in US equities and a volatility spike came alongside political concerns, trade war worries and, more broadly, concerns about a slowdown in global growth. Consistent with this, equity markets were sharply lower, and the USD strengthened a touch versus G10 and EM FX. Given US inflation was still firming over this period, US rates traded sideways.
The US rate moves over the past couple of weeks in the third phase have been much more of a financial conditions tightening event relative to the rate increases earlier in the year. Rather than accelerating growth, the nearly 20bp increase that took the US 10-year through 3% this week has come alongside stronger commodity prices and rising breakeven inflation, so this has caused US equities to fall, credit spreads to widen and the Dollar to strengthen on a broad basis versus EM and G10 FX — and produced a more severe tightening in financial conditions in the US.
Again, Goldman suggests things will probably be fine, and maybe they will – but not for the reasons the bank says. Perhaps the tightening in financial conditions will, paradoxically, end up being just what the doctor ordered for risk if falling equity prices end up prompting markets to take some of the hikes out, thereby effectively restriking the Fed “put” for Powell.
Or maybe we’ll have to wait for that “other” Fed put…