At the end of November, when the 10Y yield had just cracked 2.3%, Goldman, together with SocGen, JPM, RBC and various other banks, gave its answer to what may be one of the most important questions for the market right now: how high can 10Y bond yields go before they start to hurt equities? Goldman answered that "the equity market is still at a level that can cope with moderately rising bond yields. We estimate that a rise in US bond yields above 2.75% or probably between 0.75-1% in Germany would create a more serious problem for equity markets: at that point we would expect the correlation between bonds and equities to be more positive - i.e., any further rises in yields from there would be a negative for stock returns."
2.75% is also the level above which JPM's Marko Kolanovic said last week the 10 Year would begin to cause problems for stocks:
Going into US elections, macro systematic investors (such as trend followers and various Var-based strategies) were long bonds. While the performance of these strategies suffered, the “risk on” nature of the market reaction (bonds down, equities up) prevented a more rapid deleveraging. Yet this risk is not entirely eliminated, and should bond yields continue increasing (e.g. 10Y beyond 2.75%) this will risk an equity sell-off that usually triggers a broader deleveraging of var-based strategies.
Incidentally, according to other banks such as SocGen, the market is already in purgatory: at the end of November we showed an analysis by SocGen according to which at bond yields above 2.60%, stocks are rich relative to bonds.
In any case, fast forward to today when Goldman has refreshed its cross-asset modelling, and reports that "US 10-year rates have now overshot our 3-month forecast of 2.30%, and are now close to our Bond Sudoku macro measure of ‘fair value’, which is currently around 2.60%.
US Treasuries Have Reached our Sudoku Fair Value of 2.6%
This is the first time since 2013 Goldman reports the "valuation gap" is completely closed.
The bank then notes that based on its bond impulse analysis – designed to identify which bond market is leading the others – the sell-off in global rates is solely led by the US.
But the Goldman punchline is that with US Treasuries now at the bank's measure of fair value, they are now "starting to become a problem for the risk complex." To wit:
As a result of the strengthening of the Dollar and the increase in long-term rates, US Financial Conditions are tightening on our preferred measure. The change in financial conditions since September is roughly equivalent to 70bp of cumulative Fed hikes. As we argued in a recent note, should US 10-year rates move above ‘fair value’, this would represent a threat to risky assets unless incoming data continue to sustain the optimism they now discount.
The problem is that incoming data, if anything, indicate that the Fed is now not only behind its own curve, but that of Donald Trump, whose hundreds of billions in fiscal stimulus will only push the envelope further, and force the Fed to tighten even more aggressively as Yellen hinted during the FOMC press conference.
For now, however, Goldman has issued its warning, although it is unclear if the hypnotized, euphoric market will even bother to listen.