When will rising US bond yields become a problem for equities and risk assets more generally?
That’s one of the key questions right now, and regular readers are apprised of my straightforward position on the matter. Higher yields will become problematic if either 1) the rapidity of rate rise can no longer be described as “gentle” or “gradual,” and/or 2) real yields keep rising, bolstering the dollar and choking off the reflation trade in all its various manifestations.
I think that’s a pretty bulletproof way to conceptualize of the situation and honestly, I’m not convinced you need any additional color.
That said, incremental information is helpful, and in that regard, SocGen’s equity derivatives team wrote Tuesday that “higher nominal rates become a problem for equities when the rates versus credit spreads correlation turns positive.”
The backup in yields has increased the cost of corporate debt, but remember: That cost retreated to record lows for both investment grade and high yield borrowers in 2020, so we’re about as far away from “punitive” as it gets.
SocGen’s Vincent Cassot, Jitesh Kumar, and Gaurav Tiwari, noted that “the increase in sovereign bond yields, especially in the US, has taken the cost of corporate debt higher [but] spreads have remained stable.” That, they said, is a relationship worth watching.
“If yields keep going higher, at some stage the correlation of credit spreads with sovereign yields is likely to turn positive, leading to a sharper rise in funding costs and potentially to a selloff,” they went on to say.
They zoom in on high yield, noting that while it’s not always the case that a positive correlation between bond yields and spreads leads to a selloff, “monitoring the correlation could nevertheless give clues about the tolerance limit of the credit market for increasing rates.”
This debate is especially germane in the post-pandemic era for one very simple reason: Leverage is higher thanks to 2020’s borrowing binge.
If it was already untenable for the cost of debt to rise in an over-leveraged world, the problem is more acute now, and that’s probably an understatement.
This again argues for the necessity of ensuring that any rise in sovereign yields (and especially UST yields) is orderly and, preferably, driven by wider breakevens as economic data improves.
On Tuesday, Treasurys sold off some more headed into a $38 billion 10-year reopening. Volatility rose. “Persistent weakness in long-maturity Treasurys spurred gamma higher over the US morning, returning the 3m10y tenor to levels last seen on November 4, the day following the US election,” Bloomberg’s Edward Bolingbroke remarked.