What "The Worst Bond Rout In 15 Years" Means For Stocks

Tyler Durden's picture

In light of the dramatic spike in interest rates since the Trump victory, where as we reported yesterday and as Bloomberg comments overnight, "yields on benchmark 10-year Treasuries posted their steepest back-to-back weekly increase since 2001" leading to the "the worst rout in the fixed-income universe in 15 years"...

 

... and which coupled with a surge in the 10-Year breakeven rate - a gauge of US consumer price expectations - to the highest in more than 18 months...

... has led to the biggest, and so far unanswered, question on Wall Street trader's minds: at what level will rising interest rates pressure risk assets, and become "self-defeating", leading to broader market selloff.

Yesterday, we presented out one argument from SocGen, shown in the table below, which tried to answer this question, and found that there is still some modest breathing room, of just under 30 basis points for US 10Y yield before bond yields start "hurting equities."

However, as we also showed in light of yesterday's market performance, this critical inflection point may have already arrived, because on Friday for the first time since the Trump election, stocks and bonds both fell at the same time:

* * *

The move prompted Rick Rieder, CIO for global fixed income at BlackRock to tell Bloomberg in an interview that "the paradigm has shifted in terms of inflation. Long-end interest rates are dangerous. Make sure you are being really careful about the long-end exposure as we saw this week."

To be sure, from a purely technical basis, the bond market may be on the verge of yet another major breakout higher in yields, one which could see the 10Y sliding from its current level of 2.35% all the way to 3%: assuming trendline stops are taken out, the move may be just as violent and rapid as the recent surge from 1.78% a mere two weeks ago.

The above likely means that - at a strictly macro level - the answer how much further bond yields can rise before shattering the eerie stock market calm, will likely be answered shortly.

However, in addition to macro, one should also consider the micro, and it is here that the ongoing bond rout may have more far-reaching consequences. Recall that one month ago we posted a warning from Barclays according to which "The Party Is Almost Over As Payouts Exceed Cash Flow By $115 Billion." The implication was simple: with companies relying extensively on debt to fund stock repuchases, rising rates may soon put an end to corporate repuchases, which as Goldman recently said, were the biggest source of equity demand in recent years.

In fact, as we reported earlier today, according to Goldman, stock buybacks and dividend payments - a main reason for future S&P 500 upside - are now expected to account for a whopping 48% of total shareholder payouts in 2017, representing 48% of the total cash spent by S&P500 firms in the next year, and the most since 2007.

Buybacks alone are expected to amount to 30% of this $2.6 trllion in cash outlays (boosted by Trump's "repatriation tax holiday") or a massive $780 billion, an increase of 30% compared to 2016.

 

However, as Goldman's David Hatzius warns that there may be a problem, namely record corporate debt: "Given that S&P 500 net debt/EBITDA is close to all-time highs, firms may choose to allocate a portion of repatriated cash towards debt reduction. S&P 500 leverage was significantly below average around the time of the 2004 tax holiday."

 

A far troubling take comes courtesy of another recent report by Goldman's Robert Boroujerdi, in which the strategist makes an outright call to "Avoid the Leverage and Payout Bubble." Indeed, Goldman explicitly called the upcoming debt-funded stock repurchasing frenzy, one set to match the highet on record, a bubble.

Here is the warning:

While everyone is excited about the potential boost from fiscal stimulus and repatriation, the imbalances that have built up over the course of this cycle have not gone away. Low rates have contributed to an unprecedented corporate borrowing binge with debt levels more than doubling since 2007. However, this cash has not been used to fuel growth investments such as CapEx and R&D, but instead been simply returned to shareholders in the form of dividends and buybacks, which has not been productive, in our view. Furthermore, the slowing second derivative of a number of macro indicators suggests that we take a fresh look at the sustainability of these payouts. While not calling for an imminent cut, we see incremental risks for companies paying beyond their means on a normalized basis, particularly when the balance sheet has been extended to do so.

The problem in numbers:

  • Aggregate leverage currently sits at 1.7x, but if we normalize EBITDA, it is closer to 2.0x (ex-energy), which is a level typically associated with high yield credit. With corporate borrowing costs still near the lowest levels on record (despite the recent move up in interest rates), we think the market has been relatively sanguine about the risks associated with the build-up of debt.
  • Companies paid out 145% of their net income in 2015 (nearly double 2010’s levels) while asset age on a median basis has increased to over 7 years and leverage has nearly doubled.

However, the one bullet which in a time when rates are again expected to rise sharply, is the most critical of all, was the following:

  • Corporate debt levels have more than doubled since 2007 and 2016 is on pace for another record year of Investment Grade issuance. Interest expense is up a more modest 40% as the cost of debt has fallen from near 6% to less than 5% at the end of 2015.

The chart above shows that - at the croporate level - the biggest risk is that interest expense payments, shown by the gray line which is a function of the average interest rate, jumps sharply as it catches up to the dark blue line, the relentless, record increase in total debt, which has been the biggest catalyst for both the historic increase in stock buybacks and, by implication, the record level in the S&P 500.

As a result, Goldman also notes that that as a result of the upcoming spike in rates, the “social contract” with shareholders (i.e. returns via dividend and buyback) is in danger of dying, and lays out some stocks that are most in danger as a result:

The Death of the once ubiquitous “Social Contract”

In Exhibit 25, we list companies in cyclical sectors with a “social contract” with shareholders (i.e. returns via dividend and buyback) and high leverage. Given many companies are currently over-earning and running close to peak margins, we see risks if things normalize. Indeed, when viewed on a normalized earnings basis (i.e. 2016 dividends and buybacks paid compared to median Net Income from 2007-2016), these payout ratios would be over 100%. Further, these names have leverage north of 2x, indicating limited potential of sustaining these payouts while also preserving their balance sheets.

These 10 companies are just the beginning: sadly over the past 7 years, most corporations that had the ability, levered up to levels that are simply unsustainable during times of renormalizing, i.e., rising interest rates. For now, neither the market nor for that matter, the Fed appear to be too worried about the risk of rising rates, chosing instead to focus on the favorable outcomes from rising inflation and higher rates. However, should last week's bond rout continue at a similar pace in the near future, what was until recently smooth sailing for stocks as virtually every other asset class saw unprecedented bolatility, is about to turn quite violent.

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Pinto Currency's picture

LIBOR has been running since 2014.
Now the sovereigns yields are running:

http://www.safehaven.com/article/43077/president-trumps-immediate-emergency

Deplorable's picture

Going down\

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                                             Splattt!

 

KnuckleDragger-X's picture

how many live hand grenades can the Fed etal juggle at once? Looks like we're gonna find out.......

rmopf2010's picture

Yeah BTFD those moneychangers

pitz's picture

Good for some kinds of stocks, particularly industrials, mining, railways, utilities.  Terrible for FIRE, and basically anything that relies upon consumer spending.

 

FIRE exposure and consumer stock exposure in the S&P500 is fairly high, so the overall market is probably going down with higher rates.  Or at least stagnating, as the Dow did from 1960-1980.

Mikeyy's picture

Bonds seemy pretty sold out short-term.  I don't see a breakout to higher yields right away.

McCormick No. 9's picture

BYC (bond yield contagion) bitchez.

Dr_Snooz's picture

Memo to Trump, "never let a good crisis go to waste." This is your chance to arrest them all and throw them in jail.

I'm certainly not the only person to wonder how long the Fed can keep printing money that gets used for non-productive purposes like stock buybacks and banker bonuses. It has to end so that money can be reallocated to productive purposes again. You know, like jobs? These old crony corporations are so bloated and inefficient that they can only survive by sucking the life out of everything else. They can't keep people employed, can't keep their customers happy, can't keep their balance sheets stable or even produce goods that don't fall apart in a year. These parasites have to die so the rest of us can breathe free again.

Jungle Jim's picture

I don't understand any of this, at all. Not even a little bit.  I need someone to explain it to me like I'm five.

I don't have any kind of bonds. I don't have any stocks either. How is this supposed to affect me?

All I know is that all I have is some gold, and the gold price is biting the big one right now. THAT is affecting me, a lot. I'd like to know *why*. What have these damn bonds got to do with it?

Gadocat99's picture

You do not own gold. You may own something related to gold, but not actual gold you can hold.

Jungle Jim's picture

I don't? What are those coins in the safe then?

PhiPhi's picture

@Jungle Jim

I'm with you mate, totally finance/trader guy stuff not one piece of information for the uninitiated.  The best I could gather is the bond (basically a loan) pays a dividend or interest rate when it can evenyaully be redeemed, so a 10 year bond pays x percent per year but you get it all at the end of the 10 years plus the principal back. If the risk of the bond issuer is high i.e. they might go broke the more interest the bond will pay.  If inflation is high the more interest the bond should pay.  I haven't really got further than that accept that perhaps high inflation is expected in the future ot no one wants the bonds because of the risk.  Like me keep stacking the gold, it has it's ups and downs but an ounce is always an ounce.

Oath_Keeper's picture

Bonds are debt, the article talks about overall, companies own about 2x more debt than their earnings, mostly due to borrowing money to buy back stocks. Just like on a credit card, when your borrowing is a higher % of your income, the rates go up to borrow more. The belief is that stock prices will adjust to reflect 'normal' ratios, and thus go down, without the ability of the last 8 years dog and pony show buying stocks to keep their price inflated. Not everything in the article, but something a 5 year old should be able to understand.

edit: Also bonds can (should) go down, because no company can afford (interest wise) to sell more bonds (create debt).

 

Lockesmith's picture

Dollar strength + risk appetite.

Gold is not dollar or risk.

theFNG's picture

The FED sets short term interest rates the market sets the long term rates.  Everyone is selling their bonds because they think Trump is going to spend money like no one else has in quite a while.  This makes inflation rise.  Now those longer term bonds with their low yields wil not be keeping up with Trumpflation, so everyone is dumping them to put in other assets/stocks.  Normally high inflation would be good for Gold but no one is buying. As people sell these bonds at a discount, say getting $900 on a $1000 bond, the yield increases automatically because the new owner will make a higher yield on the $900 than the original owner would have made on the $1000.  This drives rates up.  To keep everyone buying the short term the FED must raise rates so they are competitive.  

_ArC_'s picture

Its true about Gold of an ounce will always be an ounce. But I sure hope that you are referring to a Physical Gold that you have. If you don't hold it, you don't own it!

Chipped ham's picture

You picking up what they're laying down brah?

Spifflove's picture

As interest rates rise people drop gold and earn interest.   As dollar is strong gold goes down.  Also gold was manipulated up and must fall before the next manipulation. 

CultiVader's picture

Wheres that smug asshole InnVestor to chime in right now?

hedgiex's picture

A new grid for you to play the daily volatility  1) game over for stock buybacks 2) sector rotation for equities 3) decoupling of corporate bond yields from treasuries, the latter are magnets for foreign inflows 4) strong $ 5) hawkish Fed depressing circulatory funds ...the usual asinities 6) doldrums over for hard commodities 7) oil oversupply to stay. On balance, Trump economics will work again despite all thrown at it from the 'bums' who will accumulate even more angsts. How can it be as they try to square the circle with no obedience from global markets. 

Let it Go's picture

This is a sign that in the future a massive problem is developing and it holds huge economic ramifications and major risk.  Many of us have a problem lending hard earned money out for a long period of time and we should be wary. Rates are based on predictions of future government deficits and events around the world that may or may not unfold as expected.

  If the bond market is indeed a bubble the implications of its collapse will be massive and its popping will not only affect bondholders but will test the economic foundations of both the country and the world. Bond holders would be stripped of wealth and soaring interest rates will magnify the nations debt service and rapidly impact our deficit. More on this subject in the article below.

 http://brucewilds.blogspot.com/2015/12/bond-market-bubble-ending-has-massive.html

Econogeek's picture

Seems to me we mostly agree that pricing mechanisms aren't signalling anything real, except by chance.  To say that higher yields mean bond market participants are expecting inflation is a disconnect.  Maybe, maybe not.  

I'm a bond market participant, sold at 1.75, and I emphatically did not sell because I think inflation will rise.  No connection.  I sold as a kind of 2-year-long trade.  I wanted to fade the election noise.  When it hits maybe 2.75 or 2.80 I'll look at buying again.

When the dollar/gold relationship really breaks and both rise at the same time, bonds will be going up too.  It'll be all America, all the time.  Hard to imagine the deep state types will let that last, but it'll be good while it does.