In “Mispriced Duration And The ‘Otherside’ Of Rising Rates,” I talked quite a bit about the read-through of rapidly rising real yields for growth stocks, richly-priced tech shares and speculative corners of the market more generally.
A key big-picture consideration is that because the world’s risk asset benchmark par excellence, the S&P 500, is dominated by a handful of mega-cap tech/growth stocks, global equities are more sensitive to real rates than ever.
Of course, it’s possible to quantify such things. So we need to delineate between conceptual musings and efforts to establish the degree of sensitivity with mathematical precision. To be clear: I’m musing conceptually.
But I’d note that it certainly seems as though lower and lower real rates are required to support equities. For example, Jerome Powell learned in late 2018 that 1% on 10-year reals was the breaking point for US stocks (figure below).
Note that Powell’s January 4, 2019, dovish pivot helped real rates retreat to half of where they were when the selloff began following his infamous “long way from neutral” faux pas.
You don’t need to be a quant to know that the lower rates go, the higher multiples are likely to be. It’s not a coincidence that valuations tend to expand as rates fall. I’ve long argued that equities (broadly construed) couldn’t sustain post-pandemic heights with anything like the levels on 10-year reals which triggered the Q4 2018 meltdown.
On Monday, 10-year reals extended their foray into positive territory. To be sure, they’re still barely above zero, but have a look at the familiar figure (below), updated to show recent events.
Think of reals as gravity. We were operating in a zero-gravity environment for two years. So, stocks floated away to the upside.
The blue shaded area shows the velocity with which gravity sought to reassert itself at various intervals. Over the past several weeks, gravity was particularly assertive.
The figure (below) shows the same blue shaded area plotted with the rolling change in the S&P 500, with notable moments in recent market history annotated.
The red dot marks the same episode illustrated in the first figure (above). The surge in reals that coincided with the Q4 2018 equity selloff was far less acute than what we’ve witnessed over the past eight weeks.
On Sunday, April 10, on the eve of what ended up being an 8% three-week rout in US stocks, I highlighted the same “risky business” chart in “A Fully-Priced Fed And The ‘Real’ Danger Zone.”
At the time, the black line (so, the rolling one-month change in the S&P) was in positive territory thanks to a mechanical bounce in US equity benchmarks. In that linked article, I wrote that,
The Fed hasn’t had much success recently in capping stocks, but I’d reiterate that the rally into quarter-end was a positioning- / flows-driven squeeze, not a fundamentals-based vote of confidence in the market. Indeed, stocks are now disconnected from the reality of real rates.
Three weeks and 355 S&P points later, here we are.
This time is different?
In this era if information overload I think we’ve been pushed into binary schizophrenia, living in a world of grasshopper chaos that lacks continuity and links to stability. Real rates define long-term context and act as a magnetic North reality in financial travel.
Jumping to conclusions, with ants in our pants, allows us to create narrative fantasy that catastrophe is priced into future values and that equilibrium is just a kiss away. It’s that cycling loop of ignorance that fueled pandemic excess and helps us to imagine greater upside anticipation, while ignoring all the distortions of dystopia.
I think we’re witnessing creative destruction in a new, uncharted, unmapped financial adventure.
The supercharged GFC QE model of the pandemic era, with lingering inflation, supply chain chaos and a highly volatile commodity market point toward an epic global storm that’s in an early stage of development. Obviously, this has all been priced into BTFD, but what if, this current inflation volatility plunges the other direction, into a deflationary crash?
What happens in five months, if rocketing inflation is blown apart by demand destruction? In essence, the entire pandemic era rapidly contracts into a reverse cycle of falling prices, falling stocks, rising unemployment and an even more screwed up commodity supply chain?
From Volker:
“The truly unique power of a central bank, after all, is the power to create money, and ultimately the power to create is the power to destroy.”
Agree with that comment but would add that a Geopolitical event on the Horizon could alter this scenario . I don’t think it is likely but we are skating on thin ice these days .