One of the more confounding aspects of the record bond selloff experienced in the past few days, is that it not only left broader equity indices unscathed, but took place as the Dow Jones hit a new record high. This, as Goldman explains, is problematic, given that the ‘low yields for longer’ theme, i.e., the infamous “Fed Model” which was used to justify record high stock multiples purely as a function of record low bond yields, that underpins the valuation of several financial assets is under scrutiny. As Goldman puts it: “the continued focus” on the spike in bond yields “seems to us justified.”
The reason, as Goldman’s Francesco Garzareli cautions, is that “some of the ongoing price action in fixed income ties up well with macro developments and remains overall favourable for risk assets. But other traits of the repricing seem inconsistent with fundamentals, and are potentially destabilizing for broader markets.” Where things get interesting, is where Goldman and Deutsche Bank diverge on their opinion whether the recent blow out in yields will serve to limit future equity gains.
Goldman is more sanguine:
At around 2%, US 10-year Treasuries are now at the low end of the valuation band around our preferred measure of macro ‘fair value’ in which they fluctuate 68% of the time. Bonds in Germany, the UK and Japan are priced similarly on this dimension, as shown in Exhibit 1 below (by comparison, in the Summer, the degree of departure of yields from their ‘fair’ levels was a very rare event, occurring on average less than 5% of times). The current level of long-term yields in the US and in other main economies is by no means ‘restrictive’ for growth. With both the BoJ and the ECB engaged in QE, reflecting low domestic inflation, we think the bond premium will stay in check.
As a result, Goldman believes that “risk assets have more headroom (around 30-40bp to be more specific on 10-year Treasuries, especially if the move is led by inflation) before higher bond yields become a threat for the expansion.” So call it about 2.50% before stocks stall based on yield limitations, according to Goldman.
Even so, Garzarelli admits that there is a caveat to his optimism:
The speed of the move higher in yields has been elevated. This is by no means unusual, especially when the starting point is a big departure from ‘fair’. But it comes at a time when it is difficult to ascertain how many investment strategies were predicated on yields staying ‘lower for longer’. Retail redemptions from bond funds is a dynamic that needs to be tracked if the sell-off extends. As we documented in our previous notes, the wealth exposure to rising rates is extremely high. And an increase in equity and credit volatility could follow, given the risk of a equity market correction down the line.
Which is where Deutsche Bank comes in with an assessment that is more troubling, because according to the bank’s FX strategist Alan Ruskin, the knock on effect of higher yields and a stronger dollar is now set to have a “domino impact.”
Ruskin writes that the sharp turn taken by commodities, after U.S. bond market “took down” EM assets Thursday, will add to EM pain, and adds that there are signs that higher bond yields, “knock” of stronger USD are having a “domino impact,” taking down weakest risky assets first before moving on to next weakest.
In other words, the S&P is now limited by the bond complex how much higher it can go; Ruskin then disagrees with Goldman and sasyd that the apex of risk structure, U.S. equities, will be significantly restrained by U.S. bond yields. The reason: there is only so much financial conditions tightening via bond yields and stronger USD that risky assets can take.
Of course, the financial tightening will be promptly resolved once stocks sell, and result in a bid to the bond complex, which in turn will reset the cycle, or as Ruskin puts it: “a risky asset sell-off will temper bond market sell-off and eventually USD gains in self-corrective fashion”, however his advice to investors – unlike Goldman – is that a “first port of call” for short-term trading is to take somewhat more cautious approach to risk. Said otherwise: the stock market – as usual – remains in a bizarro world of its own where nothing makes sense.
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