There doesn’t seem to be much concern out there when it comes to the potential for rising yields to derail US equities, which are perched near record highs on the assumption that as crazy as the man in the White House most assuredly is, he likely wouldn’t call off the “Phase One” trade deal with China at the last minute.
Yields rose sharply in the US last week and have now largely erased the August collapse. Some worry that rapid rate rise will eventually cause indigestion for equities, as it did in October 2018 and just prior to the VIX ETN extinction event in February of last year.
But given the pro-cyclical, risk-on nature of the bond selloff, most believe rising yields are, if anything, a positive development. Indeed, that would be consistent with the recent market mode, where the recession signal from plunging yields eventually overwhelmed any mechanical boost to equities. Since August, stocks have generally moved in tandem with yields as the latter proxies as a real-time recession barometer.
“We anticipate that clients will ask if increasing yields will at some point derail equities”, JPMorgan’s Marko Kolanovic wrote Friday, in a note documenting his expectations for a continuation of the rotation out of bond proxies and into value and cyclicals. “Our view and analysis suggest that yields can increase another ~150 bps before they become a potential problem, and that rising yields will only accelerate the upside in cyclical and value stocks as they reflect improving economic conditions”, he added.
Deutsche Bank’s US rates team seems to largely agree.
“At these levels, we see few signs that higher real term premia are potentially problematic for risk or activity. To the contrary, higher breakevens are constructive for risk”, the bank’s Stuart Sparks writes, adding that “at least thus far, the recent sell-off looks less like a 2013-style tantrum, and more like a sigh of relief”.
That’s a reiteration of the notion that while stocks were happy to rally alongside bonds for most of 2019, the August plunge in yields was too much, as it ostensibly conveyed something dire about the economy, although some estimates suggest at least half of the decline in 10-year US yields that month was down to hedging, positioning and low liquidity.
The following charts from Deutsche show the breakdown of yield rise across both the real and breakeven curves.
Sparks goes on to decompose reals and breakevens into their risk-neutral and term premium components. Obviously, term premia were heavily influenced by central banks in the wake of the crisis, as policymakers looked to drive investors out the risk curve and down the quality ladder. Naturally, the higher the real term premia, the worse for risk assets, while higher breakeven term premia tend to be a good thing for risk asset valuations.
This makes for a somewhat mixed picture in the context of the recent selloff in bond land.
“Higher inflation term premium are constructive, as moderately higher inflation implies higher asset prices, stronger corporate pricing power, higher wages, and hence stronger consumption”, Sparks writes, but cautions that “higher real term premia can have a more pernicious effect on risk”.
Fortunately, we’re nowhere near levels on the latter that should cause problems – or at least not according to Deutsche Bank. “The recent sell-off appears far too small to have material and persistent deleterious effects on equity valuations”, he writes, noting that “real term premia near historic lows remain strongly supportive for risk asset valuations [and] though breakevens have recovered modestly, higher nominal yields due to higher BEI term premium are also supportive for risk”.
As for JPMorgan’s Kolanovic, he simply notes that if you think back to 2018, when 10-year yields were above 3%, “it was at a time when central banks were hiking, the trade war was escalating, and PMIs were sinking towards contraction”.
Fast forward a year and we’re in a different place.
“Now all of these value/cyclical headwinds are abating and cyclicals and small cap stocks are still below their levels when the 10Y yield was ~3%”, Marko went on to write. “In short, a higher 10Y should be a boost for the rotation and likely positive for all equities apart from bond proxies”.