Thursday witnessed what, at one juncture, was a multi-sigma rise in 10-year yields.
The bond selloff has accompanied rampant optimism around trade and so far, equities are dancing along to record highs (at the index level, anyway).
But if the last two years have taught investors anything, it's that extreme moves in bond yields (higher or lower) are only "tolerated" by equities for so long.
How much higher can bond yields go before equities are knocked off their perch?
That's a question that's likely to be on the lips of many market participants in the weeks ahead assuming all signs continue to point to an interim trade agreement between the world's two largest economies.
Over the past two years, investors have received a crash course in the myriad factors that determine how stocks respond to dramatic moves in bond yields beyond the mechanical implications (i.e., beyond what yields say about the relative attractiveness of stocks).
For instance, in August, the furious bond rally that accompanied renewed trade jitters undercut risk sentiment, as declining long-end yields were seen as signaling something dire about the prospects for the global economy. It didn't help that the plunge ended up inverting the 2s10s on August 14 (just a day after the Trump administration attempted to ameliorate trade concerns by splitting the next planned tariff escalation into two tranches).
On the flip side, sharply rising yields contributed to the selloff in October 2018, and if you recall, "Vol-pocalypse" (the historic VIX ETN "extinction event" in February 2018) was preceded by rapidly rising yields.
The following chart shows weekly gains/losses for the S&P (top pane and bottom pane) overlaid with 10-year yields (top pane) and weekly gains/losses for the iShares 20+ Year Treasury Bond ETF (TLT):
In the lead-up to the February 2018 VIX spike (when XIV and other short vol. products were wiped out), yields rose too far, too fast. An above-consensus average hourly earnings print accompanying the January 2018 jobs report was the straw that broke the camel's back. Investors feared inflation was heating up and would force the Fed to hike rates. Stocks plunged, liquidity evaporated and volatility spiked, exposing the rebalance risk inherent in levered and inverse VIX ETPs. That week (the week of February 5, 2018) will live in market infamy.
Headed into the October 2018 selloff, 10-year yields in the US moved all the way up to ~3.25%, a level that seems almost unfathomable now. When Jerome Powell uttered the phrase "long way from neutral" on October 3, it was insult to injury. The bottom fell out for equities as the stock-bond return correlation flipped positive. That set the stage for the Q4 meltdown.
In August of this year, yields plunged following President Trump's decision to break the Osaka trade truce and announce new tariffs on China just a day after the July FOMC meeting. The move lower in yields was exacerbated by thin seasonal liquidity, a pullback by HFTs and, crucially, convexity hedging.
Around half of the August plunge in yields (and thereby the 2s10s inversion) was attributable to hedging dynamics and positioning, but the optics around what ended up being the best month for US Treasurys since the crisis were not good for risk assets - the plunge in yields suggested the global economy was on the verge of careening into a proper recession. And so, stocks reacted accordingly. August was one of only two months in 2019 when the S&P fell (the other being May, when Trump broke the Buenos Aires trade truce and blacklisted Huawei).
Now, we're facing another outsized move in yields. Although reports that Peter Navarro (probably) is pushing back on tariff relief knocked bonds off the lows on Thursday afternoon, at one point 10-year yields were up 12bps on the day. It was nearly a three-sigma move.
The recent move higher in yields has, of course, come amid rampant optimism around the trade deal which is now widely expected to be accompanied by the roll back of tariffs.
This is good news, as long as the rise in yields is some semblance of orderly. Three-sigma moves are not orderly. Eventually, that kind of rapid rate rise will spook stocks, even as it encourages a rotation to risky assets.
As Goldman has shown in the past, moves in yields larger than two standard deviations are dangerous. To wit, from a note out just prior to the February 2018 episode mentioned above:
Since the crisis, if US 10-year yields increase by more than 2 standard deviations in a 3 month period, equities have sold off alongside bonds. When rates rise too quickly, they can weigh on growth expectations and valuations for risky assets and rate volatility can spill over to equity volatility.
Those are all important points, and it's critical that you ask yourself this question: If rising yields don't get "validation" from the growth data (i.e., if the data doesn't inflect for the better), well then what do you have left? Tighter financial conditions, that's what, and that goes double if rate rise is led by real yields instead of breakevens (the ostensibly positive read-through from higher reals notwithstanding). In that context, consider the following from Bloomberg's Cameron Crise, out on Friday morning:
While the reflation theme powers on, in some ways it's been remarkably sedate. Sure, yields are pointing higher yet again and gold's gotten a smack. Yet it's worth noting that the needle hasn't actually moved that much on inflation breakevens, while equity punters haven't actually shown an inclination to buy all week once the market opens. The 5y5y inflation breakeven, for example, continues to trundle along near the bottom of its range of the past few years. That's not necessarily the worst thing in the world for risk, of course; a push higher in real rates to some degree offers a vote of confidence in the state of the economy. Yet it's remarkable how little desire investors have demonstrated to buy stocks. The SPX has been virtually unchanged between its cash open and close all week; the average absolute value of the open versus close change over the past four days has been a whopping 8 bps. That's not a record low, but it's not far off.
Meanwhile, you're reminded that CTAs have been unwinding the legacy duration long, which has likely added momentum to the bond selloff. At the same time, STIR traders have nearly priced out another Fed cut.
Also, don't let it be lost on you that there are myriad equity expressions tethered to the "duration infatuation." That is, the "bubble" in some bond proxies and low vol. stocks is in serious jeopardy on any sustained pro-cyclical rotation tied to soaring bond yields.
Ultimately, there will need to be some kind of reckoning here, unless we get a best case scenario where a trade deal is accompanied by a string of better-than-expected data and yields manage to rise in an orderly way, where that means fast enough to be commensurate with the improving macro outlook, but not fast enough to trigger a tantrum.
This is something to think seriously about as expectations for the "Phase One" trade deal continue to build.
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.