Saturday, February 19, 2011

Will Rising Yields End the Party?

Ben Levisohn of the WSJ reports, Rising Yields Could End the Party:

With corporate profits rising and economic data coming in better than expected lately, stocks are surging. But so are bond yields—and that could spoil the party.

Bond yields and stock prices have been rising together. On Feb. 8, the Dow Jones Industrial Average touched 12233, its highest level since June 2008. The same day, the yield on the 10-year Treasury reached 3.72%, the highest since April 2010. Rates have risen for six consecutive months, the longest such streak since 2006.

Signs of a healthier economy are growing more numerous by the day. The Chicago Purchasing Managers Index, for instance, rose in January to its highest level since 1988. Corporate profits also have been better than expected; more than 70% of the companies in the Standard & Poor's 500-stock index that have reported fourth-quarter results so far have beaten earnings projections.

Yet rising bond yields can cause problems of their own. Higher yields raise borrowing costs for companies, homeowners and municipalities, especially overleveraged ones. Over time, those higher costs can be a drag on corporate profits and economic growth. Rising yields also make bonds relatively more attractive than stocks for income-oriented buy-and-hold investors.

The question for investors is when bond yields and stock prices might start to decouple. Since 1963, stocks and bonds have tended to move in opposite directions whenever the yield on the 10-year Treasury note has risen above 5%, according to data compiled by LPL Financial in Boston. When the 10-year yield is below 5%, stocks and yields tend to move in the same direction.

More recently, however, 4% yields have been a pivot point—and given the surge in yields recently, that is reason for caution. On April 5, for instance, the 10-year Treasury yield briefly rose above 4% as investors worried that the Federal Reserve would have to raise rates to tamp down inflation. During the next two months, the S&P 500 fell 12%, as U.S. economic data soured and the "flash crash" spooked investors.

"If we get to 4% and it's purely a market move, then we have a problem," says David Ader, head of government-bond strategy at CRT Capital Group LLC in Stamford, Conn.

If rates rise too quickly in coming months, that could undermine any budding recovery in housing and municipal finance, says David Bianco, chief U.S. equity strategist for Bank of America Merrill Lynch. That is because mortgage rates and municipal bond yields both track Treasurys to some extent, and an increase in borrowing costs could add further stress to these fragile areas of the economy.

Mr. Bianco says a move to 4% or higher during the first half of 2010, or above 4.5% during the second half, could exacerbate problems.

"A rise above 4% characteristically doesn't trigger an economic slowdown or recession," adds James Stack, president of InvesTech Research in Whitefish, Mont. But "it will provide a headwind."

Equities could come under pressure, too, if the gap shrinks between the 10-year yield and the overall stock market's "earnings yield," a measure of a company's earnings per share as a percentage of its stock price that is calculated by taking the reciprocal of the market's price/earnings ratio. When the difference between the 10-year yield and the earnings yield drops below zero, it can signal a shift in the market, as it did in mid-2008, before the market plunged and Treasurys soared. Conversely, the ratio crossed zero into positive territory in 2004, and stocks rallied for three more years.

Right now, the market trades at about 17.2 times trailing 12 month earnings, according to Ned Davis Research in Venice, Fla. That translates to an earnings yield of 5.82%. With the 10-year yield at about 3.65% now, the difference is about 2.2 percentage points—much less than the August peak of 3.7 percentage points. And with bond yields expected to continue their rise and earnings yields to fall, it may be only a matter of a few months before the difference disappears, says Tim Hayes, chief investment strategist at Ned Davis.

Already, signs are emerging that bond yields and stocks are poised to go their separate ways. On Feb. 3, the one-year correlation between the two measurements fell to 0.43, down from nearly 0.6 in September. (A correlation of 1.0 means two indices move in lockstep; a correlation of minus-1.0 means they move in complete opposition.) That was the weakest correlation since the beginning of 2010.

Of course, this doesn't mean investors should run for the exits. Yields remain at levels that likely signal optimism about growth rather than fears of inflation. But rising yields do mean investors should exercise caution. If yields continue to rise, they should look to more defensive sectors, including energy and staples, Mr. Hayes says.

"The question is how much higher rates will the market tolerate," he says. "More often than not, rising rates ultimately become a problem for stocks."

I like Tim Hayes and Ned Davis Research and pay attention to what their models are forewarning. Another independent research firm, BCA Research, has been warning government bond buyers to beware:

"The recent breakout of the U.S. 10-year Treasury yield above 3.5% is an important technical signal, highlighting that the macro-backdrop is increasingly turning against the bond market," said BCA Research in a recent report.

"Our global cyclical bond indicators have been bearish for some time and valuation is poor in most of the major countries. The only missing ingredient for a fully-fledged bond bear market is the start of monetary tightening cycles in the U.S. or Europe. Recent comments from Chairman Bernanke, President Trichet and Governor King give us little reason to question our call that the Fed, ECB and BoE are on hold until early 2012. Nonetheless, there is room for the market to discount a faster pace of rate normalization even if central banks do not get started until early next year."

"We are not extremely bearish on government bonds in the near term because the absence of central bank rate hikes should limit the upside for yields in the coming months. Nonetheless, we expect yields to ultimately be significantly higher on a 6-24 month horizon."

Will the bond market kill the party in equities? That depends on inflation expectations and the US jobs market. So far, the latter hasn't shown any signs of a sustained pickup but inflation pressures are building, especially in emerging markets. In fact, the ECB chief recently warned that rising food demand could drive inflation:

European Central Bank head Jean-Claude Trichet said Wednesday that food prices could keep rising due to increasing demand from emerging countries and suggested a global effort to raise production in Africa.

Changing consumption patterns in large emerging countries have fuelled food prices and “it is quite possible that this will continue for a while longer,” Trichet told the German weekly Die Zeit in an interview.

“At the same time, there are huge expanses of land in Africa which could be used for agricultural purposes,” Trichet added. “We need to provide the right incentives for African farmers in this respect.”

He called the situation “an important global issue which should be taken up by bodies such as the G20” group of developed and emerging economies.

Higher prices would not force the ECB to raise interest rates but the bank would focus on avoiding “second-round effects” whereby high oil and food prices are transformed into generalised inflation.

It would watch in particular for signs of “a wage-price spiral,” Trichet said.

Countries where economic activity is pushing inflation to levels that have begun to ring alarms, as is the case in Germany, should adopt “more restrictive” policies “to avoid the economy overheating or speculation getting out of control,” Trichet said. He noted that “Germany has also succeeded remarkably well in regaining its competitiveness over the last 10 years (and was) ... now reaping the rewards of its patient efforts.”

But the ECB president cautioned that German output had not yet returned to levels seen before the global financial and economic crises.

Trichet downplayed notions that some Germans were becoming more sceptical of the 17-nation eurozone because they might have to provide substantial financial support for weaker members in the coming years. “Deep down, everybody is aware of the importance of our historic project,” he said.
Even though global inflation is on the rise, the WSJ reports that traders of U.S. federal-funds futures seemed to have less faith that price pressures will force the Federal Reserve to begin lifting its key short-term rate by the end of this year:

The central bank's funds rate target has remained inside a lowest-ever range of 0% to 0.25% since December 2008, but the market had recently forecast a higher rate by year's end after some encouraging economic data and inflation worries.

However, Federal Reserve Bank of Chicago President Charles Evans--a voting member of the rate-setting Federal Open Market Committee--said Thursday that unemployment is still too high and overall inflation to low for the Fed start raising rates.

Evans and other Fed officials this week signaled that the central bank will likely complete its current quantitative easing program as scheduled at the end of June. The program, also known as QE2, refers to the Fed's purchase of $600 billion in U.S. Treasurys to keep longer-term rates low and help speed up the economic recovery.

Evans explained that recent food and energy price increases account for only a small percentage of overall inflation.

Outside the U.S., inflation appears to be a bigger worry, which is primarily responsible for Friday's steepening of the yield curve.

A steeper curve means the market anticipates longer-term rates rising while shorter-term rates stay low.

European Central Bank Executive Board member Lorenzo Bini Smaghi warned that the ECB may have to raise rates if global inflation pressures build.

"It is a key challenge for monetary policy to avoid spillovers and maintain inflation expectations in check," said Bini Smaghi in an interview published Friday in the daily newsletter Bloomberg Brief.

Bini Smaghi's comments came on the same day that producer prices in Germany--Europe's largest economy--jumped 1.2% in January and 5.7% on an annual basis. The annual figure was the highest since October 2008.

Meanwhile, U.S. federal-funds and the bulk of the most-actively traded Eurodollar futures contracts priced in lower short-term rates on Friday, due in part to traders' desire for safe investments ahead of the long holiday weekend.

Safe-haven bids were tied to continuing turmoil in the Middle East, including citizen protests in several countries and escalating tensions between Iran and Israel.

At Friday's settlement, January 2012 fed-funds futures--measuring expectations for the Dec. 13 FOMC meeting--priced in a 54% chance for the committee to raise the funds rate to 0.5%. That's down from a 64% chance at Thursday's settlement, and a 94% chance at last Friday's settlement.

Longer-dated February 2012 fed-funds futures were no longer fully priced for the first rate hike to occur at the Fed meeting in late January of next year.

The February 2012 contract priced in a 94% chance for a 0.5% rate, down from being fully priced for the move on Thursday. A week ago, the same contract had also priced in a 40% chance for a further tightening to 0.75%.

A 0.75% funds rate is no longer factored into the February 2012 contract.

Also, a large-volume options trade performed Friday signaled expectations for a continued rally in prices--equal to lower implied rates--for second year Eurodollar futures contracts.

Brokers reported a trading firm performed 30,000 to 40,000 spreads, simultaneously buying and selling call options, aiming for June 2012 Eurodollar futures price to reach 99.125 before the calls expire in June of this year.

At the 99.125 strike or underlying futures price, June 2012 Eurodollars would reflect expectations for the implied London interbank offered rate, or Libor, to fall to 0.875%.

Libor expectations are calculated by subtracting the Eurodollar futures price from 100.

At Friday's settlement, June 2012 Eurodollar futures were 3.5 basis points higher at 98.615, projecting Libor to reach 1.385%.

Eurodollar futures reflect market expectations for changes in the three-month Libor, which is the rate that banks charge each other for borrowing U.S. dollars.

The three-month dollar Libor is also viewed as a benchmark for lending to businesses and households, and it's frequently considered as a surrogate for U.S. fed-funds rate expectations.

Elsewhere, inflation pressures are building and so are expectations of rate hikes. Unveiling the Bank of England’s quarterly inflation report on Wednesday, Mervyn King, the governor, bent over backwards to insist no decision had been made on whether, or when, the monetary policy committee should raise interest rates:
Yet, aside from a few traders in the sterling currency markets, the consensus remains that a signal on rates has been given and the next move is likely to be as little as three months away.

“The February inflation report contained two important messages,” said Simon Hayes, economist at Barclays Capital. “The first is that the MPC is leaning towards a rate rise over the next few months. The second is that the envisaged policy tightening is small and gradual and may yet be subject to delay, depending on the evolution of the data.”

Mr Hayes’s comments were echoed by many other long-term MPC observers.

The process by which economists have come to this conclusion is highly technical. Malcolm Barr, economist at JPMorgan, says it requires enlarging the Bank’s trademark fan chart showing the likely path of inflation and applying a large ruler against it to measure changes.

The reason economists have been reduced to reading the runes is Mr King’s habitually circumspect presentation on the day of the inflation report. Observers must wait for the monthly publication of the MPC minutes to discover the numbers behind the Bank’s forecast.

On Wednesday he said only that the Bank’s inflation forecast was “based on the assumption that Bank rate follows a path implied by market rates...”

A look at the interest rate futures market shows that in 12 months rates are expected to be 1.358 per cent, implying three, quarter point rate hikes by then. By August, the markets expect rates to be more than 1 per cent, suggesting two increases will have taken place by then.

Mr King, however, went to great lengths to insist the MPC “does not endorse the market path for interest rates”. “We never do,” he said.

What this tells me is that inflation pressures are building but it's too early to call for rate hikes in the US. In Europe and England, rate hikes are likely in the next few months, but expect a gradual approach if they start hiking rates.

And what about the stock market? Will the bond market kill the party in stocks? Isn't that always the case? This typically is the case, but it's not that simple. Even if central banks start hiking rates, there is so much liquidity in the global financial system that stocks will continue grinding higher and in some sectors, another bubble is already underway. In other words, rising yields will not end the party anytime soon but they will put pressure on stocks and force asset allocators to rethink their asset allocation.

But for now, I wouldn't be too concerned about rising bond yields. And don't forget, despite what some smart economists are writing, deflation isn't dead. Fairfax Financial, one of the best funds in the world, is still positioned for deflation with 89% of its equity exposure hedged through total return swaps on the Russell 2000 and S&P 500. They took a hit last quarter but might eventually turn out to be right with this deflationary macro call. If deflation fears reappear, funds should be preparing by scooping up government bonds as yields rise. Deflation might turn out to be the surprising call of the next decade.

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