There were three things that captured investors’ attention this week:
- emerging markets
- rising U.S. yields
- a close encounter of the populist kind in Italy
The first two are inextricably linked. For our latest treatment of that link, see this link (get it?): “A Visual Guide To The Strong Dollar-EM- Fed Hike Causality Chain.”
One of the ironies inherent in the current backdrop is that there are a number of potential “circuit breakers” built into the self-regulating system that we appear to be trading in. Simply put, if equities were to finally succumb to rising yields and selloff materially, the knock-on effect for financial conditions could end up prompting the market to take out some of the additional hikes, thus effectively restriking the Fed “put” and putting a floor under risk assets.
Of course that would entail equities actually selling off meaningfully and in a sustained way. So far in 2018, we’ve had two pretty acute selloffs, but thanks perhaps to earnings optimism and the corporate bid (i.e., buybacks), they haven’t generally morphed into anything that suggests a sustained downdraft is imminent.
Still, there’s evidence to suggest that the proverbial “pain threshold” for equities when it comes to rising yields is lower than it was in the pre-crisis environment. That is, yields don’t need to rise as much to flip the stock-bond correlation positive (stocks-rates correlation negative) on the way to creating diversification desperation and all the pain that comes with it for balanced portfolios and risk parity (we saw this play out in the week leading up to Vol-pocalypse and we’ve seen shades of it intermittently in the three months since).
The question, naturally, is what the “magic” number is on 10s that causes problems. Here’s what 223 respondents to BofAML’s Global Fund Manager survey say (“survey says!”):
On Tuesday, equity investors were reminded that while rising 10Y yields might not spell disaster for stocks until 4% or maybe 4.5% or maybe even 5%, the rapidity with which yields rise matters and it matters a lot. In addition to the pace of rate rise (the “how”, if you will), the “why” matters as well. That is, is it “good” (where that means growth expectations are rising, for instance), or is it bad? There’s an argument to be made that late January marked a shift from a “good” rate rise regime to a “bad” one.
It should come as no surprise given what happened this week that Goldman’s clients are (still) asking about the effects of rising rates on stocks. After all, 10Y yields touched their highest levels since 2011 (pushed up first on the back of a selloff in bunds catalyzed by hawkish comments from Villeroy and then driven rather dramatically higher following Tuesday’s retail sales data):
While reals hit the taper tantrum highs:
And so, as alluded to above, Goldman is out with yet another effort to quantify and otherwise explain the impact of rising rates on stocks.
“Lower equity prices are not an inevitable consequence of higher interest rates,” the bank writes, adding that theory aside, “empirically, during the past 20 years equity valuations and returns have often risen alongside higher rates.”
They move on to talk about the “why” and the “how” points mentioned above (and really, they’ve been over this innumerable times over the past several months). To wit:
The actual impact of interest rate changes on equity prices depends on the reason interest rates are rising. If interest rates rise in anticipation of faster economic activity, this could lift growth expectations and also lower the equity risk premium.
If rates rise predominantly due to higher inflation expectations, the ability of companies to pass on higher inflation to customers will determine whether growth expectations also increase. Core PCE measured 1.9% yr/yr in March, up from 1.5% in December. Forward-looking inflation expectations have also firmed. 10- year breakeven inflation equals 2.2%, the highest level since August 2014. Rising labor costs, commodity prices, and logistics costs pose a significant risk to S&P 500 profit margins. As a result, the ability of companies to increase earnings growth to offset valuation contraction stemming from rising interest rates may be constrained.
So that’s the “why”, and when you think about that latter paragraph, don’t forget to think about this:
Moving on to the “how”, Goldman says the following about the rapidity of rate rise:
The pace of yield increases – not just the magnitude – is also an important determinant of equity performance. Historically, S&P 500 has struggled to digest monthly interest rate increases of more than 1 standard deviation relative to the past three years. Equity returns have typically been flat when 10-year yields have risen by more than 1 standard deviation in a month (roughly 20 bp in today’s terms) and negative when yields have risen by more than 2 standard deviations (40 bp currently; Exhibit 2).
From there, it’s pretty much the same story: Goldman reiterating their call for 8 total quarterly hikes during this year and next (including the March hike) and underscoring the notion that earnings continue to argue for optimism around the outlook for equities.
When you consider all of that, you might also want to at least note that Goldman also doubts whether a short squeeze is likely to curtail the rise in 10Y yields and they’ve repeatedly called for more rebuilding of the term premium. So to the extent that entails rates rising more than 2-standard deviations in a month relative to the past three years, well then that’s trouble for stocks, according to their own math.
Then again, a 2-standard deviation move would put 10Y yields at 3.46, a full 21bps ahead of their year-end target and just 14bps shy of their 2019 target.
Draw your own conclusions, and remember, “Traders Have A Fever, And The Only Prescription Is More 3% On 10s Analysis“.