A Real Issue

The summer rally in US equities was frustrating for some fundamental strategists.

It didn’t align well with the notion that US corporate profits were destined to shrink imminently amid myriad margin threats, and all “bad news is good news” dynamics aside, it made for a somewhat awkward juxtaposition with a concurrent deceleration in some measures of economic activity.

But it did make sense in the context of falling US real yields, a boon to multiples. For the most part, the rally from the June lows was a mechanical affair, turbocharged by short covering and systematic re-leveraging, but it was helped along by an ~80bps decline in 10-year reals (figure below).

Subsequently, real yields surged, retracing the entirety of the easing impulse inherent in the sharp drop from mid-June to the first days of August, on their way to new “since 2018” highs.

Indeed, the renewed surge in US real yields is one of the key macro stories. It was both a cause and a consequence of the dollar’s roughshod run which, notwithstanding relief seen during Friday’s session, is highly destabilizing.

US stocks managed a strong week, in part due to what even Bloomberg was compelled to call “forced buying.” By Friday morning, CTAs were likely covering, according to Nomura’s models, which also suggested decent-sized buying from vol control, as the latent bid from the “catch down” in three-month trailing realized manifested in a de facto passive impulse. At the same time, the move higher in spot bled puts, while calls went in-the-money, with all the attendant knock-on effects, adding fuel to the rally. Bloomberg’s Lu Wang and Isabelle Lee (correctly) identified the presence of hedging flows, before floundering into a technically accurate, but somewhat gawky, bit about “certain quantitative traders for whom chart thresholds are a call to action ma[king] their presence known.”

What’s interesting here is that although the same mechanical, systematic flows that helped markets rebound from the June lows were back in play, real yields aren’t playing along. The grey shaded oval in the familiar figure (below, from Goldman), shows multiples have yet to realign themselves with surging reals. That’s a potential stumbling block.

“Real 10-year Treasury yields have spiked during the past six weeks from just 7bps on August 1 to 90bps today, a remarkably large jump in such a short period of time,” Goldman’s David Kostin said.

“S&P 500 equity valuations have closely tracked real yields for the past few years with P/E multiples falling as real yields rise, and vice versa [but] following the 50bps rise in real yields during the past three weeks, equity valuations have declined by a more modest 7% and trade above the level implied by their recent relationship with real yields,” he added.

In the current environment, that disconnect probably isn’t tenable. Either stocks need to de-rate or real yields need to retreat. A relatively favorable CPI report (next week) and any extension of Friday’s dollar weakness would argue for a benign outcome. If, on the other hand, dollar strength continues and reals revisit 2018 highs, expect stocks to behave accordingly.