Stocks are looking past rising yields in part because the move in reals merely marks a retracement to levels seen midway through February. And when it comes to the curve, equities tend to do reasonably well following 2s10s inversions, albeit with a wide distribution of outcomes.
Those are two key takeaways from Goldman’s David Kostin who, in his latest, noted that the recent rise in 10-year nominals counts as a three standard deviation event.
Generally speaking, moves of that magnitude (illustrated in the simple figure, below) are conducive to weakness in stocks. Remember: In the near-term it’s not (necessarily) about the level of yields, but rather the rapidity of the move, and also what’s driving it.
Currently, a two-sigma move equates to about 40bps on nominals. The red line in the figure (above) is 50bps.
So, how have stocks managed to sustain their positioning- / flows-driven rebound? Considering the composition of rate rise (reals have moved markedly higher over the same period), stocks should be weak. Higher reals is a tightening impulse, after all.
“Investors may be overlooking the recent jump because [real] rates have simply returned to mid-February levels,” Kostin remarked. The figure (below) illustrates the point.
Real rates (in orange) moved back near record lows as surging commodity prices pushed breakevens to record highs. So, the ~50bps “rise” (with the scare quotes there to remind you that reals are still negative) in reals just put us back where we were pre-war.
Any additional rise in real yields could be problematic, especially considering the current move is already 2-sigma. “We remain cautious of S&P 500 returns in the near-term,” Goldman said.
The figure on the left (below) shows just how challenging rapid real rate rise can be for stocks. Note that further abatement of the commodities rally could potentially exacerbate the situation in the event it results in falling breakevens juxtaposed with aggressively hawkish Fed rhetoric.
The figure on the right shows how stocks have performed in and around historical inversions of the 2s10s. There have been nine such instances in the past 57 years.
The median S&P return over the ensuing three months was 2%. It was slightly better over six months and very good over the subsequent 12 months (+9%).
“This pattern reflects the lag between yield curve inversion and the start of recession, during which equities typically continue generating positive returns,” Kostin remarked.
You’ll note from the “time to recession” column (in the table on the right, above) that the lag between 2s10s inversion and a downturn varies widely. It’s also notable how anomalous the pandemic episode really was. Recession came calling just seven months after the August 2019 2s10s inversion, which was precipitated by Donald Trump’s decision to break the Osaka trade truce with Xi Jinping. On August 14 of that year, Trump took to Twitter to declare Jerome Powell “clueless” and lament the “CRAZY INVERTED YIELD CURVE!”
Six months after the curve’s warning, China was locking down cities. Four weeks after that, the world briefly ended. Over the ensuing 24 months, stocks returned 54%. What a time to be alive (or maybe “clinging to life” is better).
Re: Looking past
If there is a common thread in stocks or speculation it’s risk. Risk valuation is often connected to casino probabilities and interpretation of reward related to risk. Monte Carlo geometry.
I’m fascinated by the evolution of risk perception as a social and phycological phenomenon that is metaphorically similar to airborne transmission, passing within communities, exposing people, who act as carriers that spread sequential strands of information that lies dormant, yet brewing and growing.
That risk metaphor is a paintbrush that paints a mental picture, where the content is about the assumption to look past and tune out gut feeling or to ignore risk. It’s a matter of training oneself to shrug shoulders and dismiss realities as being inconsequential.
Looking past risk is like a newfound cousin who’s part of the disinformation family and part of a genealogical inheritance of propaganda that’s almost biblically rooted in the seeds of greed.
The pandemic certainly exposed raw nerves and help expand political polarization, but it pushed society into a mutation level in terms of risk management and our new heightened ability to look past economic events.
As COVID had taken a breather, we’ve been able to tune out the pandemic costs and the two month recession of 2020, tuned out an attack on the US capital, tuned out millions of deaths, tuned out Ukraine, inflation, inversions and basically everything, as we turn back to the focus of spinning the roulette wheel, knowing in our hearts and minds that a bet on red seven will buy daddy a new pair of shoes.
Who’s got time to worry about details when our smartphones connect us to Monte Carlo?