Heisenberg Report

‘Higher Bond Yields Without Better Growth Can Quickly Become Self-Defeating’, Goldman Warns

In August, the market was reminded that although collapsing bond yields provide a mechanical boost to equities, “too far, too fast” can (and will) be interpreted as a harbinger of recession.

Once that threshold is reached, bond rallies can become pernicious, especially if the short-end refuses to keep pace, and the attendant bull flattening leads to inversions.

Given that, it came as some relief in September when yields began to rise anew off the August panic lows (and remember, some of what the market witnessed in the long-end in August was down to hedging flows). After spending the first half of 2019 squarely in the “bad news is good news” zone wherein dour data is good for bonds and stocks (with the latter benefiting from concurrent expectations of monetary accommodation), the regime has flipped.

And yet, as Goldman writes in a new asset allocation piece, “higher bond yields without better growth can quickly become self-defeating, as both 2015 and 2H 2018 illustrated”.

Just as “too far, too fast” on the downside for yields can signal recession, “too far, too fast” on the rebound tightens financial conditions and, if it’s not accompanied by better growth outcomes, serves as a “pure” drag on risk asset performance and, ironically, growth itself.

“In 2015 and 2H 2018, bond yields rose, led by US 10-year TIPS yields as the Fed tightened monetary policy, narrowing the gap to US 10-year breakevens.”, Goldman goes to recap, adding that “this created too much ‘competition from cash’ for other assets and tightened financial conditions, which weighed on growth”. As a reminder, cash outperformed some 90% of global assets in 2018.

(Goldman)

So, in order for a true risk-on, cross-asset rotation to take hold, any rise in bond yields needs to be accompanied by a convincing rebound in growth and a current rise in inflation expectations (i.e., breakevens need to lead in a bond selloff for it to be “healthy”).

“For a sustained rotation higher, bond yields should be led by rising inflation expectations, which have been closely linked to the performance of cyclicals vs. defensives, i.e., growth”, Goldman goes on to say.

And yet, any fiscal push strong enough to resurrect the reflation narrative still seems like something of a pipe dream. “Another wave of fiscal stimulus, similar to 2016, could drive such a sustained rotation but it seems too early for that”, Goldman cautions, noting that fiscal policy in both China and the US is “more constrained this time”.

The US is staring down trillion-dollar deficits thanks in no small part to the Trump administration’s late-cycle plunge into supply-side economics and Beijing is still clinging to the idea that it’s possible to keep growth relatively stable without abandoning the deleveraging campaign and without “flooding” the system with liquidity.

As far as Europe goes, Goldman writes that “a large fiscal boost supported by negative rates, might only happen if growth deteriorates further”. By then it may be too late.

In the latest edition of BofA’s European credit investor survey, clients overwhelming said the most bullish catalyst for risk assets over the near- to medium-term would be a fiscal push from Europe (read: Germany).

(BofA)

If “animal spirits” and the reflation theme fail to show up and any bond selloff ends up being led by real yields rather than breakevens, it could constrict growth and imperil risk assets anew.

On the bright side, growth outcomes tend to lag monetary policy action, so perhaps better days are ahead.

“Easier financial conditions should eventually feed through to growth, especially if policy uncertainty eases, unless the easier monetary policy YTD has become less effective in boosting growth; there is a large gap between growth and FCI changes”, Goldman goes on to say, in the course of pointing to the first signs of bottoming out in the global manufacturing slump.

“After the longest slowdown since the late 1990s, global manufacturing PMIs have increased in the last 2 months”, the bank says.

(Goldman)

Green shoots, as it were.