The Question Everyone Is Asking


There's a lot of chatter out there about falling Treasury yields and what it means for stocks.

The driver behind the move lower in yields is clearly political/policy risk.

Here's the full breakdown of the discrepancy everyone from CNBC to WSJ is talking about to start the week.

Everyone is talking about the conflicting signals being sent by stocks and bonds.

Maybe you noticed.

The question is: "what do bonds know that stocks don't?"

CNBC ran a full segment on the subject Monday and WSJ has a big piece out entitled, "Bond Market Is Flashing Warning Signal On Trump Reflation Trade."

It's really a pretty simple concept and I've been over it and over it in various posts that are too numerous to count.

The reflation narrative has manifested itself in markets via rising yields, a stronger dollar, and soaring stocks. This year, the reflation "trinity" - as I'm fond of calling it - has broken down. Here's what I mean:

So the inset there is just February, and as you can see, rates (NYSEARCA:TLT) have diverged notably from equities (NYSEARCA:SPY).

That's a bad sign. And no, this isn't technical analysis. What you're seeing there is the market fading the whole reflation story that's been driving markets since November 9. Stocks, for whatever reason (and the explanations here range from the Catalyst fund blow up to simple retail euphoria), are still bid.

In short, rates are pricing political risk or, more specifically, policy risk. There are very real questions as to the viability of tax reform (see here for a full breakdown) and the plausibility (indeed, even the desirability) of implementing fiscal stimulus when the economy is at or near capacity.

Here's how the Journal explains things in the piece linked above (my highlights):

Stocks and bonds are again moving in tandem after diverging in recent months-a sign some investors may be losing faith in the so-called reflation trade.

The Dow Jones Industrial Average has soared more than 1,000 points so far this year and closed at a record of 20821.76 Friday. Bond prices, too, are rising, driving down the yield on the benchmark 10-year Treasury note to 2.317% Friday, the lowest since late November, from 2.446% at the end of 2016. Yields fall as bond prices rise.

It is a shift from late last year when investors were selling bonds and buying stocks, anticipating that large fiscal stimulus from President Donald Trump would lead to accelerated growth and higher inflation, a bet known as the reflation trade.

Remember all the times I've talked about the necessity of maintaining a negative stock/bond return correlation or, alternatively, a positive rates/stock correlation? Well, this is precisely what I was talking about.

Indeed, political risk is quite clearly outstripping central banks when it comes to rates. Think back to last Wednesday. We got the Fed Minutes, but a few hours prior we got "positive" news out of France and wouldn't you know it, the move in 10-year Treasurys was more acute following the French headline than after the Minutes were released. Here's Bloomberg:

On Feb. 22, the same day as the much-anticipated release of minutes of the Fed's last meeting, it was a French politician named Francois Bayrou who generated the most rapid swing in the $13.9 trillion Treasuries market.

The centrist mayor from southern France triggered a roughly 3-basis-point increase in 10-year yields in just three minutes when he said he won't run in this year's presidential election. He offered to support fellow moderate Emmanuel Macron, a pact seen as potentially damaging the chances of anti-euro National Front candidate Marine Le Pen and curbing demand for haven investments.

Treasuries' intraday yield surge mid-week was noteworthy, particularly when contrasted with the slower-developing move after the release several hours later of the minutes of the Fed's last meeting. Perhaps it's emblematic of the times: Central-bank watching is passé, while handicapping political risk is en vogue.

As I wrote on Sunday evening, "yes, 'handicapping political risk is en vogue' when it comes to analyzing markets, [now] if only someone with a hat and dark glasses would have told us as much a year ago."

You're seeing the same thing in the front end of the German curve. One commenter recently suggested that falling Schatz yields aren't emblematic of risk-off sentiment tied to the French election. "Something else is going on," the reader contended.

Well, sorry but that assessment is incorrect. All we need do to see what's in the driver's seat here is compare the plunge in German 2-year yields to EONIA. Here's Goldman (my highlights):

Behaviour at the shorter end of the yield curve is consistent with these moves being driven more by flight to quality and political risk premium than by rate cut expectations. For example, while German 2y yields have fallen, the EONIA 2y OIS has remained anchored (Exhibit 3). The same has been true for intra-Euro area performance of yields - while German bond yields are making new lows, other markets have generally pulled up.

Once again, "central bank watching is passé." It's politics running this show.

And that should worry you if you're long US stocks. There's considerable event risk around Trump's policy platform. Namely, that he isn't able to deliver. If he doesn't, then yields could reprice sharply lower. That is, Treasurys could rally - and hard.

This is made all the more worrisome by the still massive spec Treasury short. Here's SocGen (my highlights):

10 year US Treasury yields fell to their lowest levels since November on Friday, flirting with 2.3% amid speculation that it will take time for easier fiscal policy to arrive in the US. Last week's CFTC data show another small fall in the net short 10year Note position and while the bond market CFTC data need to be treated with even more skepticism than the FX data, the market action supports the idea that there are still big shorts, which are being squeezed hard.

Remember, the paradox here is that if Trump musters his usual bombast in Tuesday night's address, that could be even worse for the dynamic outlined above than if he disappoints. Why? Because it would set the bar even higher in terms of expectations for tax reform and fiscal stimulus and thus raise the odds that whatever he does manage to come up with ultimately disappoints the market.

Here's the very well articulated counterargument from Goldman:

A tactical long to hedge for political risks in Europe can make sense - especially for US treasuries as the carry and long dollar exposure embedded in USTs should help. But bond yields are again at very low levels, reducing their ability to hedge. And past the political concerns, it is hard to see bonds outperforming. Exhibit 4 plots the increase you can have in 10-year yields before the coupon income in bonds ceases to offset the capital losses. For the US this is roughly 27 bp but for Germany it is only 2 bp. Bunds, Gilts and JGBs remain expensive by our metrics and even US Treasuries are becoming somewhat expensive again after having been fairly valued post the election sell-off.

Translation: this is a really, really tough spot to be in.

You can get long Treasurys to hedge political risk and take advantage of i) an expected safe haven bid, and ii) expected short covering.

But, if you're wrong, you've only got 27 bps of leeway before the capital losses from a selloff will chew up and spit out your coupon.

Meanwhile, stocks are caught in the middle. If you get a sharp repricing of yields lower, you'll almost surely see a selloff as the reflation narrative dies once and for all.

If instead yields rise, you have to worry about that 3% threshold beyond which the stock/bond return correlation flips positive.

So if you were curious to get the full story behind the whole "are rates sending a warning sign for ebullient stocks?" meme that's showing up everywhere, there you go.

Trade accordingly.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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