Fed ‘LOLables’: Nomura’s McElligott On When Rising Real Rates Will Become A Problem

When it comes to client inquiries, Nomura’s Charlie McElligott hears the following more than any other question: “At what point will equities no longer be able to handle higher real rates?”

He’s not the only one hearing that question, I can promise you that.

By now, this is (or should be) a familiar tale to most readers. In an environment characterized by a deflationary supernova (i.e., the pandemic) accompanied by an existential oil price shock, the steady rise in breakevens and accompanying lockstep recovery in risk assets was a referendum on the Fed’s success.

Simultaneously, US real rates were driven deeply negative, pressuring the dollar to multi-year lows and thereby laying the dry kindling for a reflationary impulse once someone struck a match. The matches (plural) are the vaccines and Democrats’ victory in the Georgia runoffs.

The worry (as alluded to in the chart subheader) is that any further rise in yields will see more participation from real rates. Put differently: The concern is that breakevens may be exhausted or may have even overshot, considering the macro headwinds.

Circling quickly back: What happens if real yields keep rising? When does that become a problem?

For McElligott, it’s important for folks to remember that financial conditions are near the easiest in history. Last month, they were the loosest on record (orange dot in the figure below).

A “weak dollar plus extremely low cross-asset volatility have helped to more than offset any tightening of conditions on the rates side,” McElligott said Wednesday, adding that “higher reals are being driven by risk- and sentiment- ‘positive’ catalysts,” where that means improving expectations for the economy coming out of the pandemic.

This is “especially” true when you consider “the powerful tailwinds of a pro-cyclical growth ‘fiscal embrace’ across the globe,” he went on to remark.

So, is there nothing to worry about? I wouldn’t go that far. There’s a sense in which higher US real yields are always a “problem,” for one obvious reason: They effectively represent the opportunity cost of doing anything else.

When they’re negative, that opportunity cost is less than zero. If they turn positive, then the calculus changes materially. If they rise above, say, 1%, then the whole game changes. Just ask 2018 Jerome Powell (figure below, with annotations by my buddy Kevin Muir, former head of equity derivatives at RBC Dominion):

Coming back to McElligott, he wrote Wednesday that higher reals aren’t a problem for stocks “at this juncture,” but that’s subject to change.

“If we get an unruly rates selloff and yields gap higher / bear-steepen violently, then it will be on the Fed to consider reversing course with the potential to add to QE purchases or extend WAM as needed to calm financial stress,” he said.

Then, McElligott had a little fun at that prospect, calling it “about as Fed LOLable as it gets,” to the extent it amounts to the market now fully in the driver’s seat when it comes to dictating policy outcomes.