The market continues to digest the recent move in yields and its implications for sectoral pockets. Headline indices struggle, given tech stocks' disproportionate weighting.
Tech investors continue to run the gauntlet of higher yields and less compelling valuations, but the bond market signal tells investors to trim some overweight tech.
Since early 2018, a rise in the long bond yield has sent risk tremors through the stock market on four occasions: February 2018, October 2018, April 2019 and January 2020; during all four events, the turning point was the narrowing of earnings yield premium on tech stocks due to raising of the 10-year US yields.
Concerningly, as US bond yields march higher, this suggests that the heavily weighted tech sector could be on the cusp of a very unpleasant near-near-term valuation test.
Tech-sector valuations have become extremely sensitive to changes in 10-year bond yields. So, for stock markets with a high-weighting to tech, such as in the US index, the valuation impact from a rise in bond yields can be very steep.
Bunds are down around half a point, while the DAX is off 1%. The weakness is not just confined to Bunds, though, with BTPs also struggling. It seems that the short-term boost from ECB President Christine Lagarde's speech yesterday has faded.
Still on the reflation path, but rates dynamics might be changing that course. Risk is likely still on a reflation path, but the course will get choppier from here. While vaccine distribution continues to accelerate, fiscal stimulus expectations have rerated from the low end to the higher end,
The dynamic in risky assets versus rates has shifted as stocks have been more sensitive to the downside to the higher yields. I think this is due to several things:
- 5y5y OIS (an indicator for the market's expectations around the Fed terminal rate) has fully recovered to the pre-pandemic levels.
- Long-end nominal forward rates are also back to pre-pandemic.
- Inflation assets like break-evens and inflation swaps are at or approaching the Fed's inflation target.
But ahead of Fed Chair Jerome Powell's 'Humphrey Hawkins,' the market is starting to act as if the Fed is getting closer to the point where they will have to respond or signal that they will respond accordingly or risk falling behind the curve. Indeed, very early taper jitters are entering the fray again.
And with fiscal stimulus likely to come in towards the higher end of expectations, and there is nothing Powell can say now, short of the action itself, that would be a dovish surprise to the market. Ironically, Powell's very taper tantrum risk he is trying to avoid may now be elevated as a result.
If Powell doesn't push back hard, especially as Fed funds pricing has crept inside the zero-guidance window, accepts the yield move and observes it is consistent with the pace of vaccine roll out and the economic outlook could confuse the markets.
If this were the signal, it might be interpreted as the Fed welcoming a tightening of financial conditions. And for a market fueled by liquidity, it could be a problem.
The question would be whether the past fortnight is the start of a more extensive correction or just a minor rerating to the move in rates is up for debate. Still, for now, my base case, with the pandemic continuing to normalize and more fiscal stimulus to come, means higher yields to come.
OPEC
Evidence of a tighter oil market in 2021 prompted several brokers to make upward revisions to oil price targets, which helped push Brent to a 13-month high close to $67/b yesterday. While it is true that the market is likely to be undersupplied this year, what is being ignored is the big elephant in the room—that this deficit is entirely dependent on an OPEC+ supply cut.
The artificial deficit created by the OPEC+ agreement will help to accelerate the draw-down of global inventories. Still, the upside in oil is likely to be capped by the ~9mb/d of spare capacity in OPEC+. The OPEC+ meeting next week will be the first test for the bulls.
Forex
Stocks down, bonds down, gold flip-flopping, USD/MXN ripping, USD/CNH soggy make it tough to paint a coherent picture of what is going on in FX right now.
My view is that weaker stocks would eventually flow through to more vulnerable commodities and then a stronger USD. So far, that view is doing the opposite of bearing fruit. but it's still early days in the reversion trade.
Iron Ore
Chinese iron ore futures dropped as much as 3.5% overnight after top steel-producing city Tangshan issued a second-level pollution alert, forcing mills to curb production. Output at steel mills and coking plants in Tangshan will be limited from Feb. 23 in response to expected heavy pollution. Production at hot rolled and cold rolled producers will be suspended, the local government said in a statement.
Gold
Whatever the US dollar does, gold says 'I will follow.'