I just wanted to clarify a few thoughts from my last note.
· To be clear, I do not think there is significant more upside for yields. I implied as much when I wrote that 2.5% for the 30y is quite reasonable. The inflation compensation component (which has moved the most) is back to fair value, (though at this stage of the cycle it tends to overshoot a bit) and real yields (which hasn’t moved all that much) are also broadly fair, in my estimation. Much of the reflationary reasons proposed so far remain conjecture. As a result, I don’t think fair value has changed all that much, though they will increase over time. Positioning and momentum are the key remaining drivers at this stage.
· I also should’ve clarified that I don’t think there is significant upside for equities. As noted before, many of the drivers for equities with respect to policy changes remain speculative, while the rise in long dated yields is a reality now. The likelihood of policy shifts suggests that a premium for equity prices are very reasonable. But I wrote in the summer than equities can handle a 50bp backup in yields without a problem – and 10y treasury yields already 70bps off the lows. In addition, credit markets have been much less enthused than equities. 5y Investment Grade spreads tightened just 1bp(!) on Wednesday. And finally, markets do not seem to be worrying much about the risk of a policy mistake, either at the domestic or international level. I think most would agree that those risks are higher now given the inexperience of the president-elect.
· This suggests that further rapid rises in yields here are likely to result in weakness in equity prices, which will then feed back into lower yields. This suggests that momentum across asset classes should slow.
· The fact that most of the move in US yields has been driven by the inflation compensation component rather than the real component is a key reason why the broad USD hasn’t moved all that much, IMO.
· Note also that the Fed has spent a lot of time talking about the improvement in the labor market, but the ECB has not. This is despite the fact that EU unemployment has declined by 2% from the highs already, and is now below the OECD estimate of NAIRU!
As I noted yesterday, this is probably a major reason the ECB tapering rumors are substantive. Yes, core inflation remains low, inflation expectations may be unanchored, etc, etc. But for an inflation targeting central bank, this is not something that they can ignore. The removal of ECB policy accommodation is likely to continue in fits and starts over the course of 2017, which is likely to provide support for the Euro.