We’re going to beat this poor, dead equity-rates correlation horse until it dies again, by God, because anytime there’s a notable move higher in yields, all anyone cares about is a sign flip and the prospect of a concurrent selloff in bonds and stocks.
Don’t forget, if it becomes clear that stocks and bonds no longer diversify one another, history shows that locust swarms descend on Western capitals within two weeks (on average), followed by the outbreak of disease and then, ultimately, widespread famine.
Last Wednesday, equities not only digested rate rise with alacrity, stocks actually celebrated the bond selloff on the assumption that rising long end yields represented the bond market “catching up” with economic reality. Fast forward to Thursday and stocks weren’t so sure. By Friday, it was clear that even if rising yields were “validation” of U.S. economic prosperity, the rapidity of rate rise represented a threat to equities.
The bottom line is that rising yields are fine as long as market participants continue to view rate rise as indicative of (and in step with) economic strength.
But last week felt 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”.
Of course it’s not entirely clear that what we’ve seen recently is in fact indicative of rising inflation expectations. At a certain point, the debate becomes pointless. This is complicated immeasurably by the fact that real yields are a function of inflation expectations. Given the Fed’s data-dependent lean, nascent signs of price pressures give the market a reason to expect a more aggressive Fed. Throw in the term premium debate and the waters get even murkier.
“The drivers of the recent sell-off have been difficult to decipher from the macro data [and] our markets group argue this has been an unusual sell-off in rates,” Goldman writes, in a note dated Tuesday. Here’s a bit more color from the bank:
While it isn’t uncommon for Treasury yields to increase sharply on strong economic data, a marked bear steepening in an aging hiking cycle is quite unusual. The pricing of higher policy rates over the next year contributed to some of the sell-off, but not to the steepening, much of which occurred in real yields. That bear steepening in real yields, particularly at longer maturities, appears to be technical in nature — neither a reassessment of the length of the cycle nor a fear of the Fed being behind the curve supports such a move at this stage.
Whatever the case, what we do know is that the virtuous negative stock-bond return correlation (positive equity-rates correlation) has disappeared, and that doesn’t bode particularly well for equities in the event the bond selloff doesn’t abate. Here’s Deutsche Bank’s Aleksandar Kocic summarizing why this matters in the context of the “have your cake and eat it too” environment that investors enjoyed post-crisis:
Equity-rates correlations tend to be generally positive. Either we have a recession where bonds do well and stocks underperform or a recovery with rally in stocks and sell off in bonds. Regardless of which mode the market is in, we know what to do — we exploit the correlations.
In the post 2008 recession, this was not enough. Both stocks and bonds did well. And nobody complained, because everyone was happy. While it lasted. The problem is clearly the reversal of that mode that takes us from rally in both stocks and bonds to sell off in both assets. This is the most feared scenario. And, to make things interesting, we are not very far from this regime.
Well, as Bloomberg’s Sid Verma and co. write on Wednesday, the positive equity-rates correlation that’s been a fixture of markets since 2000 has disappeared and as you can see from the following visual, it’s a rare thing that the sign flips negative:
The mirror image of that is a flip positive in the correlation between the S&P and TLT:
(Bloomberg, h/t Luke)
Again, folks are going to keep beating this dead horse until it dies a second and third and fourth time.
And that’s actually fine in this case, because although “posthumous equine abuse” isn’t something I’d list under “interests” if I were say, signing up for a dating site, I don’t mind engaging in it if I think doing so might drive home a particularly important point.
3% on 10s… pic.twitter.com/NdvmnRt75V
— Walter White (@heisenbergrpt) February 25, 2018