A notable convergence emerged in recent months: as 10Y yields - which had declined for much of the past year - spiked in early September as the market's recessionary thesis was first challenged, so did "value" and "most shorted" stocks, while former institutional favorites, growth and momentum stocks, tumbled alongside bond prices.
As a reminder, the first such notable reversal higher in 10Y Yields in 2019, which took place at the start of September, was also the main catalyst behind the infamous quant crash, which saw market-neutral momentum and defensive factors tumble the most since the infamous August 2007 quant unwind, while value, cyclical and "most shorted" stocks soared as CTAs and other position-based investors suffered a violent reversal.
To represent this correlation visually, one could look at the chart below from Michael Krause, which shows that the rolling 6-month correlation between a momentum market neutral basket and bond prices had never been higher.
Another, perhaps simpler visualization, comes from Goldman which showed that the average correlation between 10Y real yields and consensus trades had never been more negative...
... suggesting that even as stocks rose to all time highs, most investors had been bearishly positioned, with popular rotation exposure predominantly in concentrated in duration-equivalent sectors such as utilities and housing.
The above charts also explain why Bloomberg's pure momentum index - which until late August was the market's top consensus trade - has been crushed, first during the September yield spike, and then, once again, in the past week, as the 10Y yield rose to just shy of 2.00%, the highest level since July.
Yet as momentum and growth stocks suffered as bond yields rose amid rising prospects of a 'reflationary' US-China trade deal - whether justifiable or not, is an entirely different topic - cyclicals and value names, which as recently as this summered had been left for dead and had become some of the most-hated and shorted names in the market, roared higher.
All of the above goes to just one more overarching observation: in the past several months, the biggest driver for the two big groupings of stocks, cyclicals and defensives, was just one: the yield on the 10Y Treasury. As such, question about how high the yield could go before the violent market rotation below the surface finally triggered a broader selloff have become extremely pressing. Just this morning, Shard Capital's Bill Blain said that if yields rise any higher, the stock market melt-up will quickly reverse, to wit: "Rising rates have massive negative implications for corporate credit and without the juice of further central bank easing – stock markets could well lose heart."
He is, of course, right: after all it was the surge in 10Y yield in Sept 2018 as a result of the Fed's continued hawkish bias, that precipitated the Q4 2018 market crash that briefly sent the S&P into a bear market.
But, as usual, the question is just how much higher can yields rise before they trigger the selling avalanche.... and how much longer can the current rotation from defensives/momentum into value/cyclicals continue.
That, is also the question asked today by JPM's head quant, Marko Kolanovic, who for the past two years has been the bullish "good cop" to JPM's other quant, Nikolaos Panagirtzoglou, who - let's face it - did not fully appreciate the power of the Fed's "Not QE" liquidity injections (for those asking, yes - the market is up every week ever since the Fed starting "Not QE").
While Marko was indeed correct in predicting that the cyclical/defensive rotation would persist after the initial September flare out, the bullish JPM quant is convinced there is much more to go, for one reason: the unwinding of legacy positions still has a long way to go. Kolanovic explains the peculiar convergence between bond prices (inverse yields) and most crowded positions,
There is still extreme crowding in defensive styles and momentum that we illustrated in our previous reports. An additional illustration is shown in Figure 1 below. It shows two strategies that in theory should have little to do with each other: one is equity long-short selection of winning/momentum stocks (momentum factor) and the other is CTA macro investing that doesn’t even hold any individual stocks, but rather mostly fixed income instruments. One can see that recently they are nearly 100% correlated. This is yet another indication of the prevalence of groupthink and crowding across investment strategies. The most recent crowding episode was largely driven by bond yields, and fears of the trade war impact and recession. A similar level of crowding can be illustrated by the performance of small-large factor and value equity factor. In theory these should be uncorrelated, but they are effectively one and the same, and they are just the inverse of the previously described momentum strategies. Our view is that the best hedge for a continued unwind of this investment groupthink is to overweight deep cyclicals like energy, metals/mining, as well as small cap stocks.
None of that of course, is new: Kolanovic has been banging the factor compression trade for the past five months now (incidentally, anyone who followed that trade after it was first laid out in July and into the record divergence in late August got steamrolled), and he clearly see the mean reversion continuing for quite some time, even though one look at CTAs positioning shows that the long bond position has been almost unwound.
What is new, and previously unreported, is what the JPM quant thinks about how much higher yields can rise before spooking the market. Today, for the first time, he provides the answer:
Finally, we anticipate that clients will ask if increasing yields will at some point derail equities and this cyclical rotation. Our view and analysis suggest that yields can increase another ~150 bps before they become a potential problem, and that rising yields will only accelerate the upside in cyclical and value stocks as they reflect improving economic conditions.
In other words, the 10Y yield can hit 3.50% before it finally spooks stocks (incidentally, Kolanovic is looking at the wrong issue: it's not how high yields can rise, but how fast they get there as we explained back in October 2018, just after yields had soared at a staggering pace, unleashing the Q4 2018 crash).
In any case, to justify his reasoning, Kolanovic asks clients to recall that "last year we saw 10-year yields above 300bps, and it was at a time when central banks were hiking, the trade war was escalating, and PMIs were sinking towards contraction."
Now all of these value/cyclical headwinds are abating and cyclicals and small cap stocks are still below their levels when the 10Y yield was ~3%. In short, a higher 10Y should be a boost for the rotation and likely positive for all equities apart from bond proxies.
While Kolanovic's logic is sound, we disagree with his conclusion as there is one key point he forgot to note: the worse the US and global economy got heading into the fall of 2019, the more likely the Fed was to cut rates (and as we now know, launch "not QE", largely thanks to the actions of Kolanovic's employer). As such, since markets tend to be forward looking, they were pricing in an ever more dovish Fed - and liquidity injections - and that's precisely what they got. Now, on the other hand, should yields surge, the Fed will once again have to turn hawkish, something markets will once again sniff out and frontrun, and in turn start buying duration and defensive exposure. And as yields drop, so will value stocks.
There is another reason why we find it very unlikely that 10Y yields can rise to 3.50% as Kolanovic suggests. As we saw in late 2018, 3.20% is all the stock market could take before collapsing. More than one year later, and about $1.6 trillion in US debt higher, neither the US nor global economy can sustain the same interest rate that caused the last crash. As such, a 100 bps is a far better estimate of how far rates can rise before triggering another selling avalanche.
One final point: since it is the consensus trades that get crushed as yields and cyclicals rise and as defensive stocks fall, hedge funds should be praying that Kolanovic is wrong. Because if he is right, 2019 will be another year in which the vast majority of hedge funds not only underperform the market, but post negative absolute returns, and find themselves out of a job.