This is all fine and good as long as market participants continue to view rate rise as indicative of (and in step with) economic strength.
But this feels a lot like January. Remember, the market’s interpretation of rising yields can turn on a dime, and this has all the trappings of an inflation scare. When it comes to rate rise, it’s the “why?” and the “how quickly?” that matter and while the answer to the first question bodes well for risk, we might soon be answering the second question with this: “Too damn fast”.
That’s from something we did on Wednesday as the stateside bond selloff accelerated and in case there’s anything unclear there, the idea is that past a certain point, the bond selloff will imperil the equity rally.
On September 7, when the August jobs report betrayed the swiftest wage growth since 2009, I took my readers on a trip down memory lane to Friday, February 2, the last time the market was taken off guard by a well-above-consensus AHE print. That was the fateful Friday that presaged a week during which the VIX staged its largest one-day spike in history and the Dow fell more than a 1,000 points on two separate occasions.
Headed into that week, it was clear that bond yields were rising too far, too fast, and more than a few commentators suggested it was just a matter of time before the stock-bond return correlation flipped positive, leading to a selloff in both equities and bonds at the same time.
Because January marked something akin to “peak euphoria” in U.S. stocks, and because the short volatility trade was, at the time, still the most crowded trade on the planet, a flip in the normally negative stock-bond return correlation had the potential to lead to a nasty unwind in equities. Sure enough, the following week was one of the worst weeks for balanced funds and risk parity in years.
As Goldman wrote in an expansive note dated February 7, “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 last week – the last two times being during the global financial crisis.”
The issue was the rapidity of rate rise. There is a limit to the equity market’s patience when it comes to higher bond yields. Prior to late January, the bond market adjustment was viewed as a good thing to the extent it signaled something about the relative robustness of the economic recovery. But the rapidity of the rise in yields matters. Too far, too fast is not good and past a certain point, equities’ interpretation of that yield rise will change.
Fast forward to this week and the setup looks remarkably similar. 10-year yields have risen some 35bps since September 1. Meanwhile, U.S. equities have made new high after new high since August, when the S&P finally recouped losses incurred in February and March. At the same time, Jerome Powell has repeatedly emphasized how well the U.S. economy is doing.
Late last month, Goldman was out with a quick reminder of something they flagged in February – namely that “historically, when the UST 10y yield has a 2-standard deviation move over a 3-month period the equity-bond correlation usually turns positive.”
Well, in light of the ongoing bond rout and ahead of Friday’s jobs report, it’s worth highlighting some excerpts and visuals from a 46-page Goldman strategy paper dated Tuesday.
The bank begins by reminding you that “the length of the current bull market in balanced equity/bond portfolios is now the longest on record.”
The problem for investors in balanced portfolios at the current juncture is that both bonds and stocks are extremely rich:
There are two things that have, historically, derailed balanced portfolios: Growth shocks and inflation shocks. Here’s Goldman:
We find most large 60/40 drawdowns in the last 100 years have been in or around US recessions (Exhibit 6). But in the mid 40s and late 70s real 60/40 returns also stayed negative for several years without a recession due to high and accelerating inflation. Of course there have been plenty of other reasons for 60/40 drawdowns. Recent examples include Black Monday in 1987 and the 1994 bond bubble burst or around geopolitical events, e.g. the Cuban missile crisis and Vietnam War in the 60s.
Obviously, equities are prone to holding up during inflation-driven bond selloffs assuming growth is strong and on the flip side, bonds can diversify equity drawdowns during negative growth shocks assuming inflation stays anchored.
Anchored inflation is in no small part responsible for dampening the severity of bond drawdowns. “With more anchored inflation and inflation expectations since the 90s bond bear markets have become more frequent, but also shorter and more shallow (both in nominal and real terms)”, Goldman writes, adding that “since July 2016, US 10-year bonds are already down 10% – since the 90s the average nominal bond drawdown was 10% and lasted on average only 9 months.”
What accounts for anchored inflation and reduced volatility in inflation data? Well, it’s the usual suspects. Here’s Goldman:
Lower inflation uncertainty has helped reduce global term premia structurally since the 90s – inflation volatility is close to all-time lows of the 60s and 90s. This is due to central bank inflation targeting but also structural factors that helped anchor global inflation, such as demographics, EM competition and technology. And Philips curves globally have flattened, which has reduced the late cycle pick-up in labour cost inflation. Finally, as a result of the shale revolution there is also less risk of a late cycle inflation boost from oil. And recently global QE further anchored global term premia and monetary tightening globally and also in the US has been very gradual so far.
Some of that is being thrown into question. Goldman warns that U.S. investors may be underestimating inflation risk and on Wednesday morning, Nomura’s Charlie McElligott described the market’s readily apparent apathy in the following characteristically incisive excerpt from his latest daily note:
I continue to believe that the market’s skepticism on “higher inflation” to be a mis-priced risk that could further escalate the Rates selloff in unruly fashion, especially with the 1) “wage growth” story picking-up further yesterday (AMZN minimum wage hike), 2) four year highs in Crude, 3) the cycle-lows in U-Rate / another large “Labor” beat with ADPs today 4) cycle-highs in Consumer Confidence, 5) 17 year highs in JOLTS Quit Rate…all into the “real-time” escalation of the “QE to QT impulse” broad “bearish fixed-income” catalyst.
Consider that with the following additional excerpt from the Goldman piece:
Since the late 1990s global bonds have generally done well during equity drawdowns that were due to growth shocks, but results were mixed before then. In the 70s/80s stagflation bonds globally had sharp drawdowns due to oil price shocks with mixed benefit from international diversification. In case of a monetary US policy error or sharp acceleration of labour cost inflation, international bonds might decouple similar as during the 94 bond bubble burst and the late 60s. However, with increased spillovers in bond term premia, lower bond yields globally and the ‘beginning of the end of the QE’, diversification benefits in bonds might be more limited going forward.
To be clear, it is not Goldman’s base case that stock-bond return correlations flip sustainably positive amid an inflation shock leading to diversification desperation.
That said, they do caution that “from US CPI levels above 2% over a 3-year rolling period there have been many instances when equity/bond correlations turned positive.”
Perhaps more disconcerting is Goldman’s warning that the relationship between CPI and equity-bond correlations “does not appear to be linear – when positive inflation surprises become a bigger worry than negative ones, bonds are unlikely to be good diversifiers for equities and higher yields can weigh on stocks.”
Now then, who’s ready for Friday’s jobs report?