Yesterday’s FOMC statement highlighted the return of the risk of higher yields, and its possible impact on equities. As a result, it’s probably a good time to review how this risk is likely to impact risk asset returns over the course of the year.
Historically, higher yields do not have much of an impact on risk assets, unless they increase quickly. This makes sense, and is broadly a result of the fact that higher rates are usually well communicated by the Fed, and as a result broadly assimilated by the market ahead of time. When rates do increase quickly, the impact on risk assets tend to be driven by the mechanisms by which they impact the economy. In other words, the impact is determined by how the increase in yields is spread between credit, inflation, and real yields. This broadly makes sense as well – higher real yields generally occur as a result of improving growth and investment opportunities, which is risk positive. However, significant increases in the other two components are a negative for growth, and usually drive a correction. The chart below shows how those three components have evolved at the 10y tenor over the past 3 years:
What is clear is that while real credit levels remain extremely accommodative, inflation expectations are at relatively elevated levels. This is probably the most immediate danger for risk assets. As long as an increase in yields is driven by the real component, risk assets should be fine. But an increase in inflation expectations here is likely to be a bit problematic for risk assets in the short term.
There is also an additional risk. Market participants have been expecting an uptick in the economic data for a few months now. While some of that has improvement has been realized, the improvement has fairly moderate. Moreover – the surprises seem to be stabilizing. The chart below highlights how US economic surprises have been broadly stable in 4Q. But importantly, it is start to look as if that trend is played out. A simple 2 month (45 day) moving average of the series has historically been a good confirmation of the trend, and it has started to turn south. While the impact of Sandy is likely to have caused some distortions in the series, it’s probably worthwhile to note that the distortions have been positive – i.e. most data appears to have been unaffected by the storm.
None of this analysis necessarily suggests that the pro-risk move is over, but does suggest that the risks are building. With long equity views a fairly consensus one going into this year, monitoring these risks may be worthwhile.
- US Payrolls increased 155k, vs 152k exp and 146k prev. Unemployment increased to 7.8% vs 7.7% exp and prev. Hourly earnings increased 0.3% MoM vs 0.2% exp and prev. This takes the YoY rate to 2.1% vs 1.7% exp and prev.
- Canadian Payrolls increased 39.8k vs 5k exp and 59.3k prev. Unemployment declined to 7.1% vs 7.3% exp and 7.2% prev
- US Non-Mfg ISM improved to 56.1 in Dec vs 54.1 exp and 54.7 prev
- Italy Services PMI improved to 45.6 in Dec vs 45 exp and 44.6 prev
- UK Services PMI declined to 48.9 in Dec vs 50.2 exp and prev
- HSBC services PMI in China declined to 51.7 from 52.1.
- Mon: Australia Trade Balance
- Tue: EU Economic Confidence
- Wed: Canada Housing Starts