Oil And Bonds!

Oil and bond yields.

It was all about oil and bond yields on Tuesday.

In a continuation of Monday’s trade, tech struggled as bonds sold off, undercutting the broader market in the process. Time and again, we’re left to ask whether markets are capable of moving higher when tech struggles.

Note that even in locales where tech doesn’t dominate the way it does stateside, the link with bonds is difficult to escape. “Europe lacks big FANG stocks and tech is 8% of the Stoxx 600 versus ~28% in the S&P 500, yet European tech isn’t immune to rising bond yields,” Bloomberg’s Heather Burke wrote Tuesday, as tech shares tumbled across the pond (figure below).

The headlines were littered with ostensible “milestones.” 10-year Treasury yields moved further above 1.50%. Two-year yields hit the highest since March of 2020. Five-year yields were above 1% for the first time in 19 months. And on and on. Gilts led the bear steepening move. 10-year UK yields touched 1% for the first time in 18 months. Italian breakevens hit a four-year high. 10-year bunds are within 20bps of positive territory.

“I’m struggling to see how we come out of this latest Treasury selloff without a spike higher by the dollar,” SocGen’s Kit Juckes said. “The US rates market consensus is firmly that tapering starts in November and a first Fed hike is priced-in by the end of 2022, but thereafter, the implied trajectory isn’t vertiginous and with Brent above $80, there’s plenty of inflation worrying left for the markets to do,” he added, before noting that “bond yield forecasters almost always look for yields to go back up in due course, but that just means lots of people are still jumping on this bandwagon, and they’ll keep on coming until the move in yields turns risk sentiment around.”

And therein lies the problem. The threshold beyond which rate rise “turns risk sentiment around” gets lower over time as the Fed’s addiction liability vis-à-vis stimulus and markets grows. In late 2018, Jerome Powell learned that anything beyond 1% in 10-year US reals was too much for equities (figure below).

Fast forward three years and equity valuations are much richer, while reals are some 200bps below where they were when Powell uttered “long way from neutral,” setting the stage for a mini-bear market.

It’s not a stretch to suggest US equities (and especially tech) could derate materially in the event real yields were to make a move back towards 2021’s “highs” (with the scare quotes there to denote that reals are still deeply negative).

For what it’s worth, the dollar is near the highest since November (figure below).

Obviously, a resurgent greenback can be a drag on risk assets, especially to the extent it’s piggybacking on rising US real yields and/or higher short-end rates as a result of hawkish Fed banter.

And yet, even as the dollar rises, talk of a commodities “supercycle” is back en vogue thanks to a burgeoning global energy crisis which is starting to make warnings about underinvestment (remember those?) sound prescient indeed.

“While we have long held a bullish oil view, the current global oil supply-demand deficit is larger than we expected, with the recovery in global demand from the Delta impact even faster than our above consensus forecast and with global supply remaining short of our below consensus forecasts,” Goldman’s Damien Courvalin and Jeff Currie said, in the course of raising their year-end Brent forecast to $90.

Bloomberg had the boilerplate narrative. “Oil’s latest upswing has come with a flurry of bullish price predictions from banks and traders, forecasts for surging demand this winter, and speculation that the industry isn’t investing enough to maintain supplies,” a Tuesday summary read. “The jump to $80 is also adding inflationary pressure to the global economy at a time when prices of energy commodities are soaring.”

Of course, this could add to upward pressure on yields, and it could also fuel (no pun initially intended, but I’ll take it) further outperformance from energy shares and reflation expressions more generally.

That brings us full circle. Can equities continue to rise at the benchmark level with tech underperforming amid rising yields and a stronger dollar? And what about stagflation risk? It’s far from obvious that the average consumer in developed market economies is prepared for some kind of acute energy crisis just a year on from a pandemic.

If stocks were to suddenly sink, obliterating whatever tiny sliver of the vaunted “wealth effect” that accrues to everyday people, insult would be added to injury.