‘Something May Be Up’

Through Tuesday of this week, US equities and TLT had moved in the same direction for seven consecutive sessions.

The ongoing co-movement underscores the perils of a “flipped” stock-bond return correlation in the new macro zeitgeist. Recall that last week, TLT fell 50bps on three consecutive days with the S&P down simultaneously during all three of those sessions. According to Macro Risk Advisors’ Dean Curnutt, that’s only happened two other times, both during the financial crisis.

In short, the “not your hedge” dynamic is becoming quite difficult to ignore (figure below).

This has the potential to become extremely problematic for a laundry list of reasons outlined here over the past week, most recently in “We’re All Cathie Wood.”

While policymakers may yet be proven correct in their assessment that inflation will be transitory in developed economies, a sustained surge in actual, realized inflation has the potential to deliver at least two body blows to markets. I’m not convinced this is well understood.

First, surging long-end yields (and any concurrent violent bear steepener) chances an unruly unwind of what I’ve called an “unfathomably” large duration trade across assets, including sardine-can crowding into secular growth shares, tech and investment grade credit. Second, any hawkish policy response aimed at short-circuiting the inflation impulse would imperil the valuation premium assigned to some of the very same stocks.

I don’t generally traffic in hyperbole (unless it’s tongue-in-cheek), so I won’t call that “a disaster in the making.” Rather, let’s just say it’s an outcome that’s best avoided, especially considering tech concentration across benchmarks.

“A sharp rise in interest rates could prompt an adjustment in risk asset valuations, with possible adverse implications for financial stability,” the ECB said Wednesday, on the way to cautioning that,

Standard P/E ratios are more stretched in the US than the euro area. This partly reflects sectoral compositions, as US equity indices have a larger share of technology companies with higher P/E ratios, for example. There is also a marked skewness in the distribution of forward P/E ratios across firms in both the United States and the euro area, with a larger share of firms exhibiting stretched valuations than in the past. When the opportunity cost of holding risk-free assets is taken into account, valuations look less stretched. They remain near long-term averages, as investors do not yet appear to have reduced their risk-compensation preferences substantially. Real risk-free rates have declined to historically low levels over the last two decades and current valuations may rely in part on expectations that risk-free rates will remain very low for a protracted period.

That latter bit alludes to a point made here Tuesday. The Nasdaq is now underperforming the S&P despite a renewed move lower in real yields. It’s as if, suddenly, folks are coming around to the notion that valuations for some sectors aren’t justifiable no matter how punitive the cost of holding safe assets might be.

“Both Treasurys and equities were under pressure overnight with inflation concerns as the go-to explanation for the price action,” BMO’s Ian Lyngen and Ben Jeffery wrote Wednesday. “This isn’t an unfamiliar dynamic, although it’s worth noting risk assets haven’t been particularly deterred by the elevated inflation expectations until they were realized via the April CPI release,” they added, noting that although “higher rates and a steeper curve are good for corporate profitability” in some contexts, and while “an environment in which prices are rising organically should be a net positive for firms with any degree of pricing power” making stocks an inflation hedge, “this logic breaks down quickly when the nature of the increase of consumer prices is driven by a supply shock and serves as a tax on consumption as opposed to a reflection of an economy in the process of heating up.”

Weighing in, Macro Risk Advisors’ Curnutt on Tuesday flagged the co-movement in stocks and the bond ETF (figure above). “It’s fair to suspect that ‘something may be up,'” he said, adding that “no correlation regime is permanent and empirical evidence supports the notion that the transition from risk on/risk off could be a bumpy one.”

While credit spreads have compressed dramatically on the back of the Fed’s (some would say “necessary” others would say “dangerous”) efforts to stamp out price discovery, Curnutt noted that “the 3-month realized correlation between 10-year rates and IG credit spreads is positive 36%.”

It’s all about perceptions of rate rise. Why are yields higher? (Don’t give the “wrong” answer.)

“When higher base Treasury yields reflect not just better growth prospects but also uncertainty around inflation and Fed policy, higher, not lower, credit spreads may be the result,” Curnutt went on to remark, in the course of suggesting a few “tail hedges in an uncertain time.”

BMO’s US rates team drove home the point for stocks. “Layer on top the fact the higher US rates imply a greater discount factor in the basic equity valuation models and the case for flagging risk assets is difficult to ignore,” they said Wednesday.