Day after day the yields on U.S. bonds tick higher and higher. From trading around 0.5% last year, we started the year around 0.90%. Since then it has nudged up every single day to break the psychological 1% level, trading at 1.17% at the time of this writing. At first this rise was treated with a loud cheer as it suggested prospects of an economic recovery. This journey started after the Biden nomination as calls grew for more fiscal stimulus. With a Democrat candidate, it was almost certain a bill in the order of $2 trillion would be announced to salvage the U.S. economy from the pandemic induced closures. When rising yields are accompanied by robust growth, this "rising" inflation can be seen as positive. But when it is just on the back of inflation and no growth, that is typically not good for risk assets. Therein lies the problem.
There is no doubt that inflation is here and well. If one were to look at the Food Price index, consumer and commodity prices, even breakeven five-year inflation rates, they are all surging well above 2%. The Fed's delayed CPI measure may underestimate the real number, but they are happy to let inflation run hot for a while as they cannot afford to raise rates or normalize their balance sheet too prematurely. This has huge implications for asset classes but also sector allocations. During the last decade, when we had lower rates for longer and yields were on a one-way path to zero, this was a huge boost to equities and growth stocks like Technology in particular. As yields moved lower, the intrinsic value argument moved higher. However, now the same logic that provided the macro tailwind for this sector is now acting as a headwind with rising rates. According to one analyst, a 1% move higher in yields corresponds to an 18% reduction in P/E multiples. Given how high multiples are currently, this can be quite a big change. This is why money is switching out of Technology into other value and cyclically sensitive areas. But something changed this week, even value got crushed when typically, it rises on back of higher yields. What happened?
The prospects for Q121 are still dubious at best. Yes, money has been thrown in the system but judging by the horrific payroll numbers seen last week, the real economy and certainly the labor market is far from recovering. Without the right GDP growth, we could be in a period of rising inflation but less growth, namely stagflation. This is typically not a good environment for equities. If one were to see how much cyclicals have moved vs. defensives vs. what the U.S. bond market has suggested, it would imply much higher U.S. yields or a rising dollar, neither good for equities. Either yields need to move much higher or cyclicals lower. Something does not add up. As usual the equities are pricing in way too much optimism before the underlying markets.
This Friday we have the S&P 500 Index and Equity option expiration. Currently there is a lot of open interest around 3800. This means that market makers will be working extra hard to keep the market as pinned to 3800 as possible till Friday. They need to be hedged, so they sell futures above and buy futures below strike, leaving the market pinned. It gives the illusion the market is supportive, but these expirations tend to play a big role as all futures led. Perhaps following Friday, the market will be open to move more freely... the real move.
There is a lot of talk as to what the Fed does when they deliberate over their January FOMC. Now that we have a full Democrat run government, maybe some tapering of monetary policy and a bigger focus on fiscal policy is on the cards. If so, that would cause a bit of a hiccup in equities and asset markets which have been supported primarily because of this monetary policy. But the Fed knows it cannot go on forever. It also cannot normalize the balance sheet now as it would mean a collapse of markets. They are hoping for GDP growth to pick up so that they can buy themselves some time before doing so. This is wishful thinking. Perhaps the only measure they have on their hands is yield curve control. Something needs to be done before U.S. yields become a self-fulfilling prophecy and take the dollar higher with it, just at a time when the whole world is complacently short the dollar once again.
