(Bloomberg) — Volatility in the world’s largest bond market has finally caught the attention of Wall Street investors who have been immersed in stocks all year.
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The treasury rout that pushed 10-year yields to their highest levels since 2007 spurred the biggest breakout in the $8 trillion stock rally that sent the Nasdaq 100 up 45% in 2023 for the third consecutive week for the first time since December.
While debate rages over why the bond market is turning risky again right now — inflation, Federal Reserve policy and growth expectations are all in the mix — for equity investors the issue is less abstract. Risk-free incremental payouts are just too rich to turn down, especially compared to the expected returns in pricier stocks.
One metric in particular tells the story, a valuation lens known variously as the Fed model or the equity risk premium. It shows the earnings yield on S&P 500 stocks — a rough proxy for yield prospects that is a reciprocal of the price-to-earnings ratio — falling to its lowest level versus bond yields in nearly two decades.
This is chasing more and more investors away from stocks. One is Ulrich Urban, head of multi-asset strategy at Berenberg, who has been buying fixed income for high returns while gradually reducing exposure to equities.
“Given the higher real yields and particularly ambitious valuation levels for US equities, we think the risk-return looks better for bonds,” said Orban, who increased his fixed-income flexible fund allocation to 50% from 30%.
Of course, the question of what is ailing the bond market is also relevant to the investors involved, who have been counting on a soft landing in the economy to justify their exuberance. The most obvious is the concern that the Jerome Powell-led Federal Reserve will continue to raise interest rates to fight inflation. Minutes of the Fed’s July meeting released this week showed that policymakers are a little more worried about price pressures than investors might think. At the same time, higher bond prices can also be seen as constructive bets to boost growth — which is positive for stocks.
Whatever their prediction, many people are seeing prices go up. Bank of America Corp. cautioned in a note about “the world down 5%,” echoing comments by Pimco founder Bill Gross and former Treasury Secretary Larry Summers, who estimated the 10-year rate could advance to 4.5% and 4.75%, respectively.
The S&P 500 fell below its 50-day average on Tuesday for the first time in more than three months, while global bond yields hit a 15-year high this week. Investor sentiment was also affected by news of the real estate crisis in China and troubles in the shadow banking system.
With stocks and bonds selling in full swing, Cboe’s volatility index jumped to nearly 18 on Thursday, its highest level since May, narrowing the gap with the bond volatility index. The ratio of the ICE BofA MOVE Index — which measures expected price volatility in US government debt — to the VIX fell to the smallest since March.
“We are seeing signs that equity investors are realizing that the outlook is not as optimistic as once thought,” said Michael O’Rourke, senior market analyst at Jones Trading. “More selling in bonds should promote a larger stock correction as the investor must claim a higher risk premium for owning the stock.”
For its price, the S&P 500 “pays” about 4.7% in dividends, versus about 4.2% on the benchmark US bond. Moreover, the risk premium for investment-grade bonds is an order of magnitude lower with the Bloomberg USAgg index yielding about 5.1%.
Even for some of Wall Street’s biggest bulls including Ed Yardini, longtime equity strategist and founder of the research firm of the same name, relative valuations can be problematic for stock believers.
“Equities are less attractive after the big rally since October 12th and the rise in bond yields.” Yardini said. “That’s why we didn’t raise our year-end target of 4,600 when we got there ahead of schedule at the end of July.”
A deterioration in the equity valuation account may also affect flows.
Equity buyers went on strike this week, as equity funds saw $2.1 billion in outflows and a three-week inflow break, Bank of America Corp. said, citing data from EPFR Global. Meanwhile, Treasury notes saw $3.9 billion in inflows in the week through Wednesday. Investors also flocked to money market funds, with year-to-date cash flows of $925 billion as of this week.
However, placing big bets on bonds was not a winning strategy in 2023, as the current sell-off has wiped out annual gains in Treasuries. For John Rowe, head of multi-asset funds at Legal & General, which manages $1.4 trillion, the increase in returns must continue. The asset manager is already overweight in long-term bonds and equities – and is now looking to add more fixed income exposure as soon as next week if the momentum continues.
“We don’t think there is a clear fulcrum for how high nominal yields can go,” Rowe said. “After all, just 18 months ago, the current situation would have been considered implausible by most of the market.”
— With assistance from Cecil Goucher and Isabelle Lee.
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