Head of Saxo Strats
Summary: Negative US real yields have been argued is the main reason why equities are rallying despite weak economic data, but that narrative is not the full picture. Our analysis shows that equities get very sensitive to large changes in US real yields and that it drives large positive returns in US equities. In other words, equities have historically been a good hedge against large changes in US real yields. This means that we are less worried about equities should US real yields creep higher again. The biggest casualties would most likely be gold, EUR and JPY.
Last week we wrote about low US real yields and their a priori impact on growth stocks. From a theoretical perspective low interest rates causes an exponential impact on market valuation of companies with a stable growth trajectory and low variance in future cash flows. We used Microsoft as an example to show how the market was increasingly pricing technology stocks as bond proxies. In today’s research note we broaden our analysis of US real yields and show how they impact asset classes but also how sensitivity changes for technology stocks depending on the changes in real yields.
The average response shows no link between rising equities and falling real yields
When we measure daily changes in the US 10-year real yield (US 10-year yield minus US 10-year breakeven yield) against a variety of asset classes we observe the expected sensitivities to changes in the real yield. When the real yields decline gold rises, USDJPY declines and EURUSD increases. Equities across the board have a positive sensitivity to changes in the real yield which fits with the hypothesis that rising real yields are a positive sign for economic growth and thus equity values.
Many would argue that it does not fit if they overlay the inverse real yield with the NASDAQ 100 Index. But the reason why cannot do that is that US real yields is not a stationary time series since 1999 and thus this method would be flawed. We are left with analysing changes in the US 10-year real yield and daily changes in asset classes.
It is all in the tails
Instead of only measuring the average response between change in the US real yield and daily changes in asset classes, which is what we are doing in a correlation analysis, we can do a quantile regression and measure the sensitivity across the entire distribution of US real yield changes. Our hypothesis has been that plunging real yields have driven up long duration assets such as gold, growth stocks and real estate. As the plot of our quantile regression fit of daily changes in NASDAQ 100 against daily changes in the US 10-year real yield shows, the sensitivity to changes in the real yield is almost twice as large in the tails (both positive and negative) compared to when real yields are hardly moving. This means that when the US real yield is changing a lot it has a large impact on the daily returns in the NASDAQ. In both cases it leads to higher positive daily returns in NASDAQ 100 which makes equities an unique asset class relative to changes in the real yield compared to other asset classes.
In other words, the persistent decline in the US 10-year real yield over the past 60 trading sessions is what is likely driving some of the gains we are observing. Outside the regimes of larges changes in the US real yield the NASDAQ 100 is driven by the underlying expectation for profit growth and other factors.
In the case we see a reversal in the US real yield we would expect gold, JPY and EUR to come under pressure, but also high yield corporate bonds. Depending on the size of the move equities could hold the line except many in some of the most speculative segments of the equity market.
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Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
With the economic slowdown, quality assets will gain favour, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
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