How far will yields blow out and stocks fall?

I noted earlier that the US inflation panic is likely to drive yields higher yet. For how high we turn first to BMO:

The selloff in Treasuries appears to have stabilized overnight after 10-year yields reached as high as 1.331% and 30s touched 2.11%. These extremes were accompanied by an elevated volume profile with cash trading at 226% of the 2-week norm and 10s garnering 37% of the trading activity – with much of Asia still on holiday. The overseas open on Thursday will prove yet another test of dip-buying interest as rates are back to February 2020 levels. The slope of the curve is even more dramatic, with 2s/10s reaching 121 bp for the first time since March 2017 – the peak from December 2016 of 137 bp is an obvious target in the event we’re in the midst of a bearish respite rather than a bullish reversal. With 2-year yields at just 11 bp, the bulk of the heavy lifting for further steepening would clearly be a function of underperformance of duration. The other benchmark curve of note, 5s/30s, pressed as steep as 155 bp on Tuesday, offering further satisfaction to those in the steepening camp. The balance of a sharply steeper curve while rates remain in a historically low environment isn’t lost on us. In fact, with 2s/10s establishing a local high of 121 bp while 10s managed to backup to just 1.331%, investors are left to contemplate just how far the ‘best case’ steepening can extend.

Using the 2016 post-GOP sweep and all the pro-business/reflationary fervor that accompanied it as a guide, while conceding 2s are effectively locked in an 11-13 bp range, this puts the outer-bound for 10-year yields at 1.48%-1.51%. These are levels that certainly conform with our broader range trading thesis for the year, although we’d expect more than a little support for 10s to develop as 1.50% comes on the radar. 5s/30s have already broken through the comparable steeps, leaving this reflationary trade with remarkably little technical guidance between 155 bp and 175bp on the journey to the 2010-2014 plateau of 200 bp. Let’s not get too far ahead of the momentum currently at play in the Treasury market. While it’s certainly tempting to use those prior periods as important milestones, the realities of navigating out of the pandemic are anything but obvious as this stage.

In keeping with the theme of the price action itself being the ‘event’ this week, there was very little of relevance in terms of data or information flow overnight. Certainly nothing to warrant at 5 bp peak to trough move in 10-year yields. The underlying bearish impulses credited for the recent selloff remain well intact; progress toward a fresh round of stimulus continues apace, stocks are effectively at record highs with the S&P 500 already +4.7% year-to-date, reflationary ambitions are alive and well with 10-year breakevens at 225 bp, and the winter storms have left the front-month WTI contract above $60/barrel. This backdrop speaks to this week’s early price action as offering a comparativelyclean’ read of investors’ reaction-function to a technically driven backup in yields.

1.5% on the 10 year is a shoo-in to my mind, via Nordea:

2013 tells us that the Fed struggles to separate tapering of asset purchases and lift-off expectations. What is clearly different today is the Feds introduction of Average Inflation Targeting. So far this has kept lift-off expectations muted despite an increase in term premiums and long-term rates/inflation expectations, but, and that is a big but, the average inflation targeting regime (with vague mechanics and no actual proposal of a mathematical reaction function) has yet to be tested. This is likely to happen during Q2 2021.

We see several interesting similarities to the fundamental backdrop ahead of the taper tantrum in 2013, whywe find 2.0 taper tantrum risks elevated. Back in 2013, positive data surprises during 2013, in combination with the proposed tapering from the Fed, gave rise to a huge bond market sell-off. Today, the upcoming reopening of the economy thanks to wide-spread vaccinations coupled with leading indicators pointing towards a strong growth and inflation rebound increases the likelihood of a similar bond sell-off.

Markets will likely again find it hard differentiate between tapering and a quicker future lift-off, should the Fed be “forced” into debating the balance sheet during Q2 due to elevated CORE inflation.

…Naturally, the changes in the rate expectations in the USD forward curve carry spill-over effects to EUR curve. Zeroing in on the EUR forward curve in 2013, however, reveals moderate increments in the ratio of 1:2 compared to the USD curve, and the EUR curve sensitivity to USD-curve developments has likely not increased since; rather the contrary. We see two reasons for a more material relative widening of the USD-EUR forward curve in the case of a 2.0 taper tantrum: First, the EUR curve was more alive and kicking back in 2013 as the ECB didn’t launch its QE program until 2015. Second, the ECB and the Fed’s QE programs are not even close to being in sync and the growth rebound and inflation expectations are on different planets in the Euro area and in the US.

…The huge increase in excess reserves in commercial banks may end up impairing banks willingness to hold Treasury positions, and we see a strong reverse relationship between reserves and primary dealer positions in US Treasuries since 2010. The correlation broke down when the Fed temporarily exempted banks’ holdings of Treasuries in the leverage ratio. This exemption is due to run out 31st of March pending on further decisions taken by the Fed, which may influence banks Treasury holdings due to the influx of reserves stemming from the drawdown of the TGA. This could be potential big negative news for bonds on top of the rising inflation and risk of a tantrum scare. Buckle up.

Finally, we mustn’t neglect the robots and their MOMO, via Nomura:

10yr UST yield above 1.3% or above 1.5%? The difference could mean much for the stock market

The potential for CTAs to go further short UST futures, what it would take to put the 10yr yield above 1.5%, and when US equities might balk Global macro hedge funds and CTAs seem likely to ease up on their selling of USTs at a 10yr yield in the 1.3%-1.4% range.

• However, if it becomes the market consensus that the global economy is on its way to looking like it did prior to the US-China trade war, the 10yr UST yield could potentially keep climbing past 1.5%.
• We would expect only a mild downward adjustment in US equities if the 10yr yield stays between 1.3% and 1.4%, but in a risk scenario in which the yield tops 1.5%, US equities could correct downward more sharply.

…Trend-following CTAs are in a similar boat. There are precedents that suggest that in terms of the timing, CTAs and the like may wind down their selling of USTs any time now. As shown in Figure 2, CTAs’ current short TY positioning has been following an up-and-down rhythm quite similar to that observed in 2011-2013. Also,in terms of the absolute level, CTAs’ net short position in TY is now looking less underdone than it had been relative to macroeconomic fundamentals. Considering the present state of global economic momentum (as measured by the manufacturing PMI readings for the US and China), CTAs will probably have built up an adequate net short position once the 10yr UST yield is established in the 1.3%-1.4% range (see Figure 3). Fig. 3:CTAs’ net position in 10yr UST futures (TY) vs. US & Chinamanufacturing momentum(1) US & Chinese economic performance at around the present level implies a CTA position index of around -1.0; (2) US & Chinese economic performance at around the 2017 level implies a CTA position index of around -2.5.

There is comfort in those corrected balances of Treasury holdings. But the test is yet to come as the coming inflation pulse hits the data. To my mind, it will be more buying opportunity for bonds but, as Nordea notes, that may not be how the market sees it. If so, the robots will exacerbate the move as they always do.

As for stocks falling, I’m inclined to see it two ways. An inflation surge will encourage further value rotation from growth. But, given I see it as a short-term phenomenon, I’m more included to see it as buying opportunity for the latter.

David Llewellyn-Smith
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