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The Big Conversation

Episode 96: Will repricing rates impact stocks? 

This week we look at the repricing of interest rate risk that is taking place at the front end of yield curves. Investors are throwing in the towel on the transient inflation narrative and yields have shot up. Yield curves should flatten, but there is also the risk of a VAR shock at the back end of the curve that is not currently being factored in. How should investors approach these risks and where can they look for appropriate hedges?

  • Roger: We are now starting to see a rapid repricing of interest rate risk at the front end of the curve as many investors throw in the towel on the transient inflation narrative. But could a sudden surge on yields at either the short or the long end create the sort of shock that might have a much bigger impact than any rate hike by the Fed? The market is pricing higher interest rates as a solution to a problem that is not about too much demand, but is about too little supply. Whilst higher interest rates have historically been used by policymakers to rein in an economy that is running too hot, it will do very little to alleviate the issues of supply where prices, particularly in the energy space, are not the result of a booming economy but a broken supply chain. As a result, any tightening of policy may have a bigger impact on financial assets than it will on demand and inflationary bottlenecks. Tighter policy may reduce demand, but it would be doing so from an already impaired level, which increases the risk of pushing economies back towards low growth or even recession. So what's actually happening in interest rate markets? Well, there's a significant repricing of risk at the front end of the curve. In fact, the sell-off in the Eurodollar Dec. 2023 contract is more impressive than the equivalent contracts decline during the taper tantrum of 2013. In the U.K., the repricing of rates risk is even more extreme, with the short-selling Dec 2022 contract having collapsed in recent sessions in anticipation of a series of rate hikes that many expect will commence before the end of this year. If we get a big move at the front end of the curve, then we should expect yield curves to bear flatten - and that's when the short-dated yields rise towards the level of the longer-dated yields - and that flattens the curve. So far, the back end has actually kept pace with the front in many cases, with curves in some places steepening further. Expectations remain, however, that central banks would be quick to intervene if these long-dated yields rose too quickly. They would, however, be prepared to let shorter-dated yields rise and hence the expectation that curves will eventually flatten. As already noted, the Eurodollar Dec. 23 contract has been breaking down through key support levels. The U.S. 2 year government bond yield is now starting to break out from its range of the previous eighteen months. But as ever, we have to be careful what we wish for. If curves were to excessively flatten, then it would eventually lead to an inversion, and inverting curves have been a precursor to every recession over the last 40 years. And that's not too far-fetched at this stage. Surging energy prices have also been a precursor to many recessions over the last decades, including three of the last four. Many recessionary indicators have started to pick up in recent sessions. There are, however, also significant risks that longer-dated bond yields may not be as benign as policymakers would hope. Across the back end of many curves, we can see the formation of reversal patterns appearing time and time again. U.S. government 10-year yields look like they are in the process of creating a reverse head and shoulders. A similar pattern is also being repeated on the German government 10-year bond, known as the Bund. And the UK 10-year gilt looks like it's leading the way. This has already broken through the neckline, and yields have accelerated higher. Although UK 10-year yields are still below their US equivalents, UK 2-year yields have accelerated above the US, fuelled by that expectation that the UK is on the verge of hiking rates to combat inflationary bottlenecks. Here we can see the curve flattening in action in the UK 2-year to 10-year space, which is far more dramatic than other parts of the UK curve, such as 3 months versus 10-year. Will this flattening be repeated in other regions too? Whilst the bear flattening is on the cards for many we still have to be wary of the bear steepener where long-dated bonds sell-off, and their yields rise at a faster pace than yields at the front end. The German yield curve looks like one of those reversal patterns, suggesting that it's the longer-dated yields that have the most potential to rise. This type of action could easily lead to a VAR shock that destabilises markets. Now whilst the base case may still be for flatter curves, institutional investors are looking at hedging some of these inflection points with puts on long bonds. For retail investors, ETFs on long bonds such as the TLT are displaying similar chart patterns, with a potential inflection point for an accelerated sell-off of around 135 on that TLT. So far bond volatility, as represented by the MOVE Index, has been well behaved and this looks more attractive than equity volatility, where high levels of skew mean the protection costs remain relatively elevated. And you may recall that at the end of 2018, high yields were eventually the destabilising factor for equity markets, which resulted in a 20 percent decline in the S&P 500. And that was assisted by a misstep from the Fed when they raised interest rates into the December FOMC that year. Today's Fed may not however be as trigger happy. Some of the personnel changes that have taken place in light of the trading scandals have already seen the FOMC become more dovish. Now, if Powell were not to serve a second term, then his most likely replacement, Lael Brainard, is also seen as being extremely dovish, and the market may have to recalibrate its expectations for policy. Regardless of the response, many of today's problems would still remain. Demand is well below the pre-COVID levels. It's the problem with supply chains that the issue and this can't be offset by small adjustments to monetary policy. The second issue that could create a perfect storm for policymakers is if the VAR shock in the rates market leads to a surge in the US dollar. The dollar is normally a safe haven, and if higher yields started to take their toll, then the US dollar could rise further. So far, the dollar has been grinding higher, and again it's rejected a minor resistance level in recent sessions. But higher yields and the higher dollar would significantly tighten financial conditions. And a stronger dollar would be deflationary in nature, and that could take some of the sting out of the current issues. But once again, if we are dealing with supply chains rather than demand, then even a strong dollar will have only a limited impact. So what are investors looking at beyond buying protection against the surge in bond yields? Should they continue being long value plays such as banks, which could succumb to either flatter curves or a slowdown caused by those rapidly rising yields? Now, many people are looking at some of the commodity plays, but this is not like the period from 2003 to 2014, which saw both a surge in price and volume that was a major benefit to the stocks themselves. Today's bottlenecks are more about price than they are about volume. Copper has broken out of its wedge formation. This has helped European mining stocks recover back through their support levels. But this is still really about the underlying commodities. And if there is a scarcity in copper because of underinvestment in mines, then it's the recycling of copper, which will become big business to compensate for the lack of extraction. Additionally, the outperformance of energy stocks versus the broad market is beginning to take shape though it's been a bit of a slog so far. Chronic underinvestment in this sector as well over the last 10 years means that energy issues could persist for some time. The ratio of the European energy sector versus the STOXX 600 looks like it's now forming a reversal formation, and this pattern has been repeated by the ratio of the US Energy ETF, the XLE versus the S&P 500 ETF. These sectors on both sides of the Atlantic look like they are poised to breakout on a relative basis. On the downside, the Korean stock market has been struggling. Korea is a relatively open and cyclical economy reliant on exports and growth. And she imports much of her energy requirements. The KOSPI 200 was one of the market leaders during the reflation repricing at the end of last year, but since then, it's gone almost nowhere and has recently been breaking down. The German DAX has a very similar chart pattern to the KOSPI but with a lag. The DAX is also an exporter that benefits from growth within developing economies. The index is vulnerable to slowing growth and the impact of higher energy prices on demand and margins. U.S. tech stocks are caught in a bit of a no-man's land, they have tended to perform best when yields are falling. Therefore a surge in yields would have a negative impact on these names. But if higher yields were a short-lived affair because of a VAR shock, which then sees bond yields drift back on a policy response, then many investors will be looking at that dip in tech names to add to positions. It would need higher yields to be maintained for an extended period for this sector to come under long-term duress. Many names in this sector will continue to be supported by ongoing buyback programmes. And for emerging markets, high commodity prices should be a benefit for those that are resource rich, but it's clear from their performance so far that inflation is creating significant headwinds. Resource-rich emerging markets, like many commodity stocks, are suffering from the fact that higher prices are not necessarily being matched by larger volumes. In fact, higher prices can be an enormous drag on consumer sentiment, and that's already happening in the US, and these issues are often more acute in developing economies. And EM would also be extremely vulnerable to a surge in the dollar. Some EM currencies have been under pressure for a while and continue to make new lows versus the dollar, such as the Turkish Lira. But most investors will still be looking at hedging broader-based market measures such as the dollar index, the Euro or the UUP ETF. And finally, we should probably take a look at gold. Often cited as an inflation hedge, gold should be doing better today given the backdrop. But gold has been tracking the inverse performance of nominal US bond yields over the last two years. Gold has therefore been struggling with a rise in yields that we've recently seen. And will central banks cap yields with the threat of yield curve control or will yields continue to track the moves in WTI and break-even inflation expectations? The current chart pattern for gold looks like a carbon copy of the chart pattern in 2013. Now it could be that this time it ends up being a wedge formation that breaks higher, and that's the beauty or difficulty in technical analysis. There's a lot of uncertainty about how this will play out. Therefore, rather than play gold outright, investors could look at the options market. Gold implied volatility is about 14. This is low on a historical basis, having been significantly lower only during the period around 2017 to 2018. And gold is really a play on excessive policy intervention rather than inflation, though one can lead to the other. But right now, policymakers are thinking about reining in those excesses. That could well end up being a policy error, given the lack of growth is being hidden by these inflationary assets. But tightening increases the risks that gold could fall again. Most investors still see gold as an insurance policy, that is bought and then held, but some investors may want to look at these levels of volatility to hedge existing gold exposures. Now that obviously depends on individual tolerance levels and investment time horizons. But one thing is certain, the rate curve is repricing. If it's contained to the front end and the curve doesn't invert, then we could be in for stock rotations rather than risk off events. But if policymakers lose control of the back end, then global risk assets will come under pressure at a time when there is very little organic growth to offset those higher yields. And as always, if you have any questions about this episode, financial markets or the economy, please either put them in the comments section or send them to TBC@Refinitiv dot com. [00:00:00][0.0]