By Laura Cooper, macro strategist at Bloomberg
Rising U.S. real yields could eventually derail the everything rally. Gains across stocks, credit and emerging markets are predicated on forever-loose monetary policy, and lofty valuations are harder to sustain when conditions hint at future tightening.
Stimulus-fueled growth prospects have rekindled the typically positive relationship between real U.S. yields and inflation expectations. And that can trigger outflows on higher-yielding assets like equities.
Market-based inflation expectations are comfortably priced for a medium-term overshoot, above the Fed’s 2% target. Near-zero Fed rates sent real yields deeply into negative territory last year, without the growth-element to boost nominal yields
As a massive fiscal impulse underpins the economic recovery, a corresponding increase in policy tightening expectations could drive up the inflation-adjusted benchmarks, removing a key tailwind to the broad risk rally.
And even more fiscal spending, with an infrastructure package in the pipeline, could test the Fed’s resolve to contain the supply-driven rise in nominal yields, pulling real yields higher.
The Fed risks getting caught behind the curve should tapering bets ramp up as the economic recovery extends. That raises the odds of a repeat of 2013’s taper tantrum. When real yields rose sharply, more than nominal rates, the repercussions rippled across risk assets -- over a four-week period, the S&P 500 fell 6%, EM equities tumbled more than 15% and speculative-grade credit saw spreads blowout by ~100bps.
Higher real rates could make the greenback more attractive, for example, at a time of already stretched net-short dollar positions. That in turn, can upend the risk rally with the dollar dominating in risk-off periods, as evidenced by the negative correlation with the S&P 500.
Alternatively, real rates can grind higher should steadying or softening price bets on disappointing economic data challenge priced-in expectations.
That could come from realized inflation falling short of lofty expectations. Beyond a bout of coming price pressures due to last year’s crude oil price collapse, risks to sustained inflation remain owing to labor market slack and the risk of virus variants.
Further out, a rollover in the China credit cycle could temper the red-hot commodity rally; a driving force of the climb in U.S. breakevens, and consequently, negative real rates. The credit impulse is already slowing (as Zero Hedge first reported two months ago).
Of course, a modest rise in real yields on bullish growth prospects can be absorbed and a steepening TIPS curve is desired by policy makers. But material upside is harder for the Fed to contain with the 5-year segment of the curve key to watch. With the Fed focused on achieving full-employment, nominal yield suppression is likely to extend. But while the argument to not fight the Fed stands, there will be a lag with policy makers reactive, not proactive in preventing a bond rout.
The writing may soon be on the wall for the buy-everything-but-bonds rally, with focus on inflation fears and subsequent Fed tightening. Yet it’s rising real yields that might prove to be the ultimate stumbling block for the risk rally.