Beyond 3.5%, The 'Rotation' Becomes Disorderly
A low cost of capital is the underpinning of much of the exuberance that shareholders are showing for stocks as management are able to lever-up (in the face of deteriorating fundamentals) to reward shareholders (via buybacks or state-sponsored dividends). With rates surging in the last few days, a critical question is how much will it take to accelerate outflows from bond funds and lead to significantly wider credit spreads for corporations? As BofAML notes, the consensus is now that a 3.5% 10Y rate is enough to trigger a disorderly rotation by which institutional investors are unwilling (based on risk expectations) to bid for the yieldier credit market debt as retail flows out. This is crucial since if the credit markets sell-off, firms will be unable to fund the expectations priced into equity markets and lead to a shift back to the sidelines from risk-assets in general.
With a 14bps move higher in 10-year interest rates over the past two days, the key question is how much will it take to accelerate outflows from bond funds enough to lead to wider high grade credit spreads? While we already expect outflows from (non-short term) funds to increase based on the move in interest rates so far (see Figure 4 at the end of this piece), clearly a move to 3.0% on the 10-year over the next several weeks would lead to much more meaningful outflows. Whether such scenario actually leads to wider credit spreads depends on the extent of institutional buying interest at the new more attractive levels. That in turn depends on whether interest rates are perceived to stabilize at the new higher levels – thus the other key variable to watch is rates volatility.
Our latest Credit Investor Survey, conducted July 8-11, showed that 3.5% on the 10-year is most commonly thought of as the trigger of a disorderly rotation – i.e. higher interest rates leading to outflows and wider credit spreads – among high grade investors.
Put differently, 3.0% on the 10-year will not lead to overall wider credit spreads if there is enough buying interest from institutional investors (though note that the 10s/30s spread curve would flatten further, as mutual fund/ETF holdings are concentrated in the belly of the curve, whereas institutional demand is disproportional in the long end of the curve). However, if the probability of a further move higher in interest rates to 3.5% is high – which will be the perception if interest rate volatility is high – certain institutional investors will choose to remain on the sidelines.
Thus there may not be enough institutional buying interest to mitigate retail fund outflows and contain overall high grade spread levels.
The bottom line is: if firms are unable to borrow cheap to fund the buybacks and dividends that investors have become so enamored with (and conditioned to); a disorderly rotation from rates will in fact have a major negative on equity prices as capital costs surge making shareholder-friendliness uneconomic... considering by far the greatest aspect of EPS beats has been a reduction in the float via buybacks, the fear should be that the much-hoped-for rising rate scenario (lauded by so many as indicative of great things ahead) is in fact nothing but flow-driven abd will crush EPS.
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