step_ahead_ofthemarket

BONDS or EQUITIES? JPOWs major dilemma|YIELDS|INFLATION|MACRO|

SPY/IEF  
SPY/IEF  
This will be a relatively detailed idea, but bear with me. There will be plenty of charts that speak for themselves, so I'll try to keep it as short as possible. Since everything is connected, the analysis will contain three parts, including yields, inflation , macro indicators. I will post an additional analysis of equity factor performance during rising yield spreads, sometime in the near future.

Firstly, SPY / IEF is an interesting ratio if we disregard the negative dividend carry. Given the recent volatility in the bond markets, I chose to use IEF instead of TLT , however the difference is not that major when it comes to moves of the 10 and 30 T bonds. EIF principally holds 10 year US treasuries, with an effective duration around 8.

I ) YIELDS
In essence what the charts shows is that whenever the ratio has been near the top of the channel, an equities correction has followed. There are many reasons why bond yields affect equities. The main reason of course being, the fact that yields are used as a discounting factor, higher yields imply lower present value. This is particularly detrimental for growth stocks, whose cash flows Secondarily, higher yields also imply higher interest expenses, which in an extremely debt ridden economy, companies in the junk spectrum are particularly sensitive to. More on this later.

An even more interesting ratio is the IWM / IEF ratio. The reason here being that companies with small market caps tend to have larger betas, and the higher the beta the larger the systematic risk exposure. Based on the argument above, higher yields certainly implies higher systematic risk. Therefore, at the point at which yields become troublesome, this should be first be observed in IWM / IEF ratio.
The current consensus is that bond yields will start to hurt equities around the 1.4%-1.5% range. However, these levels can still be considered at the lower range, considering that in the previous three cycles the 10Y-2Y spread returned to 2.5-3%, marking a full inflation expectations recovery (https://fred.stlouisfed.org/graph/fredgr...). Below are charts 10Y treasury charts for the past 10 years and the past year.
What seems to be the problem is the sudden acceleration in rising yields, marked by the breakout from the Biden factor initiated momentum channel. In theory, a higher bond market volatility , is quite an issue for volatility targeting strategies, as they are forced to decrease overall exposure, further exaggerating the ongoing crisis.
II) JPows dilemma, bonds or equities?
For the past 10 years, the average inflation for most economies globally has been well below their CBs targets. I guess this inspired the FED this time to even encourage inflation expectation beyond the 2-3 % range. The actual problem here of course is that bond holders would require compensation for the inflation premium. Why hold assets that essentially decrease your purchasing power?https://fred.stlouisfed.org/graph/fredgraph.png?g=BphU
The past week, with a conjecture of many factors 10Y yields have been completely out of control. There are two main ways to deal with rising yields in a debt ridden economy, implement yield curve control (YCC), Japanese or Macro Prudential way. It's extremely difficult to know exactly how equities will react in the short and long run, and whether the Japanese example is of any relevance. But what's certain is that, a Japanese YCC would cap rates at a given rate (let's say 1%), by setting a price at which the FED buys treasuries excess supply of treasuries. This case is the most bullish for equities, as the monetary base further expands. The question is whether this is constitutional. The Macro Prudential way, would be to force savings institutions (pension funds) to hold more treasuries, driving yields lower. In essence, this would imply a transfer of wealth between the borrower (young) and the saver (old) on a massive scale. This is the bearish case for equities, as the funds would have to decrease their equity holdings in order to buy more bonds. (Idea attributed to R. Napier)

Of course, the FED could also decide to do nothing, in which based on similar occasions in the past, we should have a minor correction and/or choppy markets in the near term. I am not even going to guess which direction will the FED choose, we'd just have to wait and see. Any YCC measures would be particularly detrimental for banks. The financial sector has been picking up momentum against tech for the first time in more than three years.

III) Is inflation really, really coming? Macro indicator analysis
The economy seems to have rebounded extremely well. Here's why.
Capital expenditure bounced of extremely well, compared to 2009 and 2001 (https://fred.stlouisfed.org/graph/fredgr...).
The same could be said for Durable goods (https://fred.stlouisfed.org/graph/fredgr...) and new housing permits (https://fred.stlouisfed.org/graph/fredgr...). Unemployment declining rapidly, but is still high (https://fred.stlouisfed.org/graph/fredgr...), which in essence is quite bullish as it implies a accommodative policy until "full" employment is achieved. And of course, corporate earnings are set to rebound https://fred.stlouisfed.org/graph/fredgr... Likewise, HY credit spreads are at the lowest levels they've been in the past 20 years (https://fred.stlouisfed.org/graph/fredgr... and https://fred.stlouisfed.org/graph/fredgr...). Savings rates are high, especially the latest reading for January, an increase of nearly 10% (https://fred.stlouisfed.org/graph/fredgr...) implies for a further potential that the saved money will be put into the economy once it reopens. Money supply growth is at the highest levels recorded for the past fifty years (https://fred.stlouisfed.org/graph/fredgr...). Additionally, wages pressures that are mainly legislative should also drive demand pull effect on inflation .
Each of these measures to a large extent imply a risk of overheating once the economies fully reopen (perhaps this summer). On a global scale, Chinese GDP is "apparently" rebounding, and the Eurozone is noticing first signs of inflation picking up.

However each of these measures is troublesome. There are many reasons but I will go through them briefly. Firstly, the housing market is since a long time has been dysfunctional. The rent moratorium implies, that there is additional debt accumulation, that'll drag down spending. Additionally, foreclosures seems to be postponed, driving the real estate supply squeeze. Savings rate are mostly accumulated by high earners with arguably much lower propensities to consume. Higher minimum wage pressure could easily be negated by business hiring less workers or lower hours worked. The most important factor of all is the fact that the dis-inflational tech/innovation factor still persist, and is perhaps even stronger than ever.

At this point I'd argue that since the breakeven inflation rate is still below 2.5-2.7% which has been the top range for the past 20 years(https://fred.stlouisfed.org/graph/fredgr...), inflation risks are perhaps too far exaggerated. Yes, governments are directly sponsoring extremely risky loans to business (CARES act), dramatically increasing money supply. However, at the end of it all governments can raise taxes directly or indirectly(locally), to cover for these fiscal expenses, which is especially viable right now as the Dems hold a trifecta in DC. This should also take care of Money supply growth. Come second half of 2021, we will see the kind of tax amendments the Biden admin will propose. Retroactive tax code changes would be particularly detrimental.

This is it for this detailed macro top-down analysis. There are many other factors to analyze, but the analysis is already extremely elaborate. In the following weeks, the key events to follow are, the quarterly triple witching, how the FED decides to deal with yields if they continue to climb towards 2 %, and todays vote on monetary stimulus and minimum wages. Dip buying may seem very attractive at this point. However, I would caution buying any dips as long as the bearish trend in 10Y treasuries persists, and at least wait until the markets are past the triple witching. In my next idea, I will evaluate performance of equity factors for the last 20 years.

-Step_ahead_ofthemarket
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Comments

What I forgot to mention is that the FED could also use good old QE, that targets the long end of the treasuries structure. However, this will depend on their willingness to further expand the FEDs balance sheet capacity.

QE is a less radical version of the Japanese YCC, which would be in any case quite bullish for equities, depending on the B/week.
+1 Reply
thanks
+1 Reply
@Dr_Roboto, You're welcome! :)
Reply
Dr_Roboto step_ahead_ofthemarket
@step_ahead_ofthemarket, I did not know much about bounds. This was very helpful. I can also tell you put a lot of time into it.
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