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Friday, March 29, 2024

After 7 Months The Most “Bizarre” Divergence Is Over: Implications For Markets

Courtesy of ZeroHedge View original post here.

One of the most bizarre decouplings in capital markets following the March crash, was the directional divergence between real and breakeven rates, something we addressed two months ago in “What’s Behind The Bizzare Break Between Breakevens And Crashing Real Rates.” However, in recent weeks, this unprecedented divergence appears to have finally ended, because since the start of August, US 10y rates have increased from 51bp to 74bp on the back of inflation expectations moving higher alongside real yields (+10bp).

As Goldman’s Alessio Rizzi puts it mildly, “a positive correlation between 10y breakevens and real yields has not been a feature of 2020”, which after hitting 7 months before finally inflecting, has been one the longest periods with breakevens and real rates moving in opposite directions.

The previous longest such period of divergence was exiting GFC, when similarly to now, the Fed committed to keep financial conditions easy and anchored nominal rates while the economy was improving from depressed levels. In a risk-on environment – such as the one since March – this usually pushes inflation expectations higher, real rates lower and nominal yields remain roughly unchanged.

In fact, as we have discussed previously, lower real yields provided a strong support for valuations while growth expectations were improving at the same time. And, as Goldman echoes today, “longer-duration equities like Tech and Gold have been the key beneficiaries in this regime while the dollar usually suffers.” For this reason, real rates correlation with the S&P 500 remained firmly in negative territory over the last 3 months.

Of course, the flipside to this is ominous: if lower real yields were supportive for asset prices, then rising real yields will likely lead to a decline in risk assets. Sure enough, as Goldman’s Rizzi observes, “given the negative correlation between real rates and equity, many investors are wondering if a potential rise in interest rates driven by real rates could weigh on risky assets.”

In response to such concerns, Goldman suggests that it is the speed of the move that will matter most. In the next chart, the Goldman strategist plotted S&P 500 monthly returns based on US rates moves since 1998, when the negative equity/bond correlation regime started. The chart shows that higher nominal yields have usually reflected better growth and positive equity performance. And while a 2-sigma increase in nominal yields (which would equate to +41 bp currently) has on average led to relatively flat S&P 500 returns and positive equity/bond correlation, Rizzi warns that “investors should be more focused on an equivalent increase in real rates.” In fact, a swift move higher in real rates (roughly +31 bp now) usually weighs the most on equities.

Looking ahead, Goldman notes that positive news on the vaccine together with a Democratic sweep in the US election could further interrupt the negative correlation between breakeven and real rates, as both could move higher together further. In this scenario, Goldman sees the potential for “a large rotation into more reflationary and risk-on trades and equities might be able to digest higher rates if supported by positive growth sentiment.” As such, even a jump in rates could end up being friendly environment for risky asset… as long as real rates don’t move too fast.

Which could be problematic, as the gamma positioning is already betting on a sharp – and potentially quite rapid – move higher. Why? Because as the last chart shows, the positive option skew on US bonds suggests markets are already discounting the potential for US rates to move higher.

The question is how fast will this move be once it begins, because if it leads to another sharp correction in risk assets, then the reflationary move itself will be unwound, taking us back to square one.

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