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On Thursday, the 10 year bond yield had a very large spike. It went up 14.4 basis points to 1.525% which is close to where it was before the pandemic. As you can see from the chart below, there was an intraday spike which is a big deal given how well followed/traded this asset is. Ignoring this gap up, no one should be surprised by the increase in the past few weeks. Now that it’s clear the pandemic is near its close, why shouldn’t the 10 year yield get back to where it was prior to the crisis? In fact, growth and inflation should be above normal because of all the fiscal and monetary stimulus in the past year. The 10 year yield can easily go to 2% later this year.
Some speculative stocks have been falling in concert with the 10 year bond. We’ve mentioned in the past that valuations got so high even getting to a 2% yield could spook traders. This factor/sector rotation has been caused by investors betting on the reopening stocks, while selling the stocks that did well during the shutdowns. Most companies probably haven’t seen this large of a shift in their intrinsic values, but we have come to expect overreactions especially in the past year.
Thursday was different from the past few days. Earlier in the week, only the speculative stocks fell. On Thursday, most stocks fell. Even the stocks that are supposed to do well with higher rates declined (banks). As you can see from the chart below, the rolling 24 hour equity correlation with treasury futures went positive which is different from the past few months. The sharpness of the selloff in bonds may have scared some investors.
Real Rates Are Now Rising
It seems the Fed isn’t worried about the move in yields and there is no threshold where the yield becomes a problem, judging by the comments below.
Of course, if the Fed gave a threshold, the market would instantly push towards that level. It’s the equivalent of a child seeing what they can get away with. When the rules are defined, the boundaries are pressed.
Secondly, no one knows the level that causes problems. For example, no one knew exactly when the speculative stocks would fall. Also, few would have predicted the small banks to crater on a day where yields spiked. The KRE regional bank index was down 2.95%. That’s unusual on a day where yields rise, let alone rally higher. This index actually underperformed the S&P 500.
The real rate is now spiking. That is different from the previous rate increase in the past few months in which the breakeven rate spiked and the real rate fell. As you can see from the chart above, the real rate significantly increased in a short amount of time. This was the biggest increase since March 24th. The 5 year TIPS rate increased 25 basis points and the 10 year TIPS rate increased 20 basis points.
The intermediate term rate increased more because the coming spike in economic growth won’t be permanent. It will probably last much less than even 5 years. This gap up looks a lot like the spike in late March when the stock market bottomed. Within a couple weeks, the spike reversed course. This time the increase is probably more sustainable because the real yield is so negative and breakeven rates are so high.
Negative Term Premium
As with the real rate, the 5 year breakeven rate is much higher than the 10 year rate. This is a negative term premium. As you can see from the chart below, this is the largest negative gap in history.
The gap was only briefly negative in 2007 and 2008. We’ve never seen such a temporary boost in the economy. This isn’t like the expected boost after the tax cut which failed to impress investors. This time the economy is going to fully reopen after being shuttered. The upper income class will launch a huge amount of capital at the leisure and hospitality industry. This means the term premium can get more negative in the next few weeks.
What Actually Drives Valuations
Valuations might not simply be driven by rates which makes sense because investing is all about expectations, not the current state. If investing was about the current economy, no one would be buying leisure and hospitality stocks because travel is still a fraction of what it was before the pandemic.
As you can see from the chart below, it’s not the inflation rate that drives multiples. It’s the volatility of inflation.
Low volatility and low inflation made investors think low rates would be maintained indefinitely. That’s partially why we saw valuations spike so high in the past few months. We don’t need the 10 year yield to get to 4% to change investors’ positioning. We need to have enough people scared of 4% yields to get a reaction in the equity market.
When valuations are above normal based on low rates, fear of higher rates will cause some investors to sell their stakes. There is no exact level that will make investors think such high rates are coming. However, spikes like the one on Thursday can go a long way in changing sentiment. To be clear, we used 4% as an example of an unlikely level that would definitely change people’s models by a lot.
A 2% 10 year rate should only cause a modest shift in prices, but the impact will probably be larger than models suggest because of the speed of the move and expectations. Of course, the speculative stocks got so high that no rate level truly justified their prices. The spike in rates was simply an excuse to sell these names off.
Conclusion
Treasury yields spiked on Thursday. This time was different than the rally in the past few months because real yields spiked. The Fed said it wasn’t concerned, but obviously this will be an issue if it continues. What really drives down valuations is inflation volatility rather than just inflation. Expectations for higher rates can suppress multiples this year.
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