Ever-lower real rates required to support equity valuations—mechanical sell-off can be attributed to rising real yields
Fed only cares about inflation—downtrend in markets will not revert until / unless inflation shows signs of being under control
Perilous environment ahead, where equities are a compelling short and bonds a veritable minefield
This may be the most important chart today
The chart below depicts how ever-lower real interest rates over the years are required to support equity valuations. Declining forward Price-to-Earnings (fP/E) multiples clearly align with inverted real yields.
OK, so what are real rates and what is so important about them to tank the market?
Real rates are inflation-adjusted interest rates (e.g. if the 10-year nominal rate is 1% and inflation expectations over that period show 2%, “reals” would be negative 1%). We tend to use the terms “yield” and “rate” interchangeably.
Real Yield + Inflation Expectations = Nominal Yield
This effectively means that real rates tell us how much we are getting paid to hold a bond after inflation. A negative real rate entails paying to hold a bond.
Now look at the graph above again. The real return of US treasuries was negative for the better part of the pandemic—a relatively novel phenomenon. This explains why investors were structurally incentivized to “move up the risk curve” into equities / corporate credit, expanding fP/E multiples and driving down corporate bond yields (i.e. companies had access to cheaper financing).
Flywheel turns doom loop. Tides turn.
Now, zoom in (below) and we can see that equities ($SPX) continue to track real rates closely today, albeit with a short lag.
And that’s indeed what we have experienced over the past two months—10-year reals shot up ~150bps driven by tightening policy expectations (primarily!).
With the Fed removing its accommodative monetary policy (i.e. hiking and balance sheet reduction) and by signaling their preference for tighter financial conditions (i.e. rising real yields, lower stocks, widening credit spreads and dollar strengthening) reals have entered positive territory.
Investors are naturally fading riskier equities / corporate bonds, so fP/E multiples continue to contract and corporate financing is turning more expensive.
As Andreas Steno puts it: Powell’s money printing machine used to go BRRRRRRRRR, now it goes RRRRRRRRRB. It has inverted and is now taking its money back.
In this perilous environment I continue to find equities a compelling short and all bonds a veritable minefield.
Wait, this looks familiar? Path ahead might be different this time, though
Toward the end of 2018, Powell & Co understood the hard way that a 1-handle (>1%) on 10-year reals—slightly north of 3% in nominals—was the breaking point for US equities. Signaling of tighter conditions through its now infamous “long way from neutral” faux pas launched an exceedingly dour end-of-quarter for the whole equity and credit complex.
We all know the story. The Fed was forced to make its dovish pivot on Jan 4, 2019 catalyzing an epic reduction in real rates from where they were when the selloff began. Markets shot higher.
In 2018, inflation was anchored and within the Fed’s mandate (<2%) and unemployment at record lows. Their reaction function to collapsing markets was naturally different back then.
There’s a lesson somewhere there… and it is that this is likely not what happens this time. Not unless inflation is brought under control.
This time, the Fed has made extremely clear their dual mandate has morphed into a single mandate.
Not many things will change the Fed's stance. Addressing inflation is their only concern right now, so they will tighten until inflation subsides. Period.
Even at the expense of higher unemployment (3.6% as of April).
Tradeoffs, tradeoffs. Oh… and by the way, this never works.
Short-term, we may have cleared some of the oversold conditions mentioned in last week’s post (#2 FELIZ SINK-O DE MAYO!) when the $SPX was sub-4,000, through a light bounce and some horizontal consolidation (i.e. trading in a range for some time).
Expect the market to rebound lightly and continue to whipsaw lower in coming weeks, once it digests the last stumble.
I continue to approach the market on the short side—short the main indices ($SPX, $QQQ) and credit ($HYG, $LQD, $HYGH, $LQDH). Really think twice before you buy anything (longs) and be very careful here as the combination of today’s options positioning and dismal liquidity can rip your face off. Risk management is key, as a rally / short squeeze is very possible.
Paraphrasing Kevin Muir, come for the content, stay / subscribe for the memes!
Thanks for reading,
PS: If the market has not been treating you well lately, don’t despair. At least you weren’t holding $LUNA to the moon with a tattoo on your shoulder.