Deutsche: "Either The Central Banks Lose Credibility Soon Or The Markets Have Overstretched Themselves"
Some unpleasant observations from Deutsche Bank below for fans of either central planning and/or risk assets, as having one's cake and eating it too is no longer an option, and one or the other is finally set to snap. To wit: "Yield curves are very steep suggesting a challenge to central bank guidance credibility is at a tipping point. Either the data really are strong and the central banks lose credibility soon or the markets have overstretched themselves, allowing for a partial recovery in lower rates." A "tweeted out" Bill Gross is praying to the Newport gods it's the latter.
More from DB's Francis Yared and Dominic Konstam:
We don’t think a move to 3 percent or higher in ten year yields is sustainable in the short run since it more likely than not undermines riskier assets. 5y5y approaching 5 percent should trigger real money “buying” interest at the expense of riskier assets. 5y5y can eventually get to 5 or even 6 percent but only when nominal growth is that much higher.
Nominal growth in q2 was around 3 percent, continuing a pretty consistent deceleration for several quarters. Higher rates has not been about better growth but the hope for better growth and more importantly the Fed’s hope for better growth. There are reasons to be optimistic that growth will be better into 2014 thanks to significantly less fiscal tightening in the US as well as Europe. However we estimate the market is pricing for nominal growth to accelerate to around 5 percent around the turn of the year, based on equity price performance and the selloff in 5y5y rates. This seems excessive.
Global rates curves have steepened significantly in the sell off, led by the UK and the US with the exception of Japan. 5y5y vs. 2y2y conditioned on the rate level looks very high across the markets. These moves have been consistent with repricings in short rate strips markets that pivot rate expectations around central bank “guidance”. We interpret the steeper yield curve as a stretch of central bank credibility in that it seems unlikely that curves can steepen more with either rates rising or falling from here. Curves are much more likely to flatten, either bearishly or bullishly rather than steepen. Bearish flattening represents an actual break in central bank credibility. Bullish flattening would represent an unwind of the risk premium that has been added in the past weeks.
The danger of a disorderly adjustment comes via the marginal investors in fixed income and equity product. Because mutual funds appear to be most overweight fixed income versus equity relative to pre crisis we can assume they are a good candidate to be the marginal investor. Their “nested” Great Rotation therefore runs the risk that as flows move out of bonds into equities, the compression of the equity risk premium is so dramatic for the wrong reasons i.e. rising yields not falling earnings yields that effectively the rotation is interrupted and foreshortened. Fixed income investors become “trapped” in fixed income product at depressed prices and it takes that much longer, if ever, to return to pre crisis asset class weightings. As of now this is very evident based on fund flows in q3 to date that appear to be double the rate in favor of equity versus bonds and compared with q2. Given the very sharp compression in the equity risk premium for the wrong reasons, the historical relationship suggests that flows out of bonds to equities are unlikely to accelerate and might actually cease or even partially reverse.
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