Rising Yields Trigger Risk Off

Posted By Darren Winters on Oct 12, 2018

Rising Yields Trigger Risk Off

When rising yields trigger risk-off then a stock-market sell-off typically unfolds. The theory goes something like this,as safe-haven assets, such as high-grade sovereign bonds yields rise, they become more attractive to investors. So demand for low-risk bonds with high yields rises as investors pile in to take advantage of the higher yields and relatively low risk to their capital.

Income-seeking investors will move capital out of stocks and into bonds when the yields on those bonds provide a greater return on their capital than stock dividends. A rational investor will think why take risks to their capital when the rewards are no greater
So rising yields trigger risk-off because investors rotate out of stocks, a relatively riskier asset class into bonds.

October is a notorious month for a stock-market sell-off

Rising Yields Trigger Risk OffCould the recent rising yields trigger risk-off and give this October stock-market sell-off even greater downside momentum?

The likelihood that rising yields trigger risk-off sentiment is a current hot-button topic amongst the investment community and it is for good reason. October has commenced with turmoil in the bond market.

In short, heavy selling on the bond market has caused bond prices to tumble and sent their corresponding bond yields soaring, bearing in mind that bond prices and bond yields move in an opposite direction. So as bond prices fall that also causes corresponding bond yields to spiral.

Have investors/traders entered a zone in which rising yields trigger risk-off?

US 10-year yield reached a fresh 7-year high last week of 3.23% (October 5) in a backdrop of goldilocks unemployment date which indicated that the jobless rate has fallen to lowest in 49 years. The US economic growth story is now hard to mock. Jobs have been created across all sectors, according to the latest jobs report. Employment in professional and business services increased by 54,000 in September. Healthcare employment rose by 26,000. Employment in manufacturing continued to trend up in September (+18,000) so too Construction September (+23,000).

Even the missing piece of the economic growth puzzle, rising wages is starting to fall in place as a record record net 37% of small business owners reported they are raising wages in the hope of retaining employees in what “has been described as the tightest job market in decades,” according to NFIB’s latest monthly jobs report. Moreover, the US Trucking Index is hovering near its historic high of 854 (at the time of writing this piece) which is a further indication of an active domestic economy.

So the rising yields trigger risk-off scenario could be flawed if investors are rotating out of bonds and into stocks because the buoyant US economy makes stocks more attractive.

That is the bullish view but don’t take it to the bank because it too is obviously flawed. Why then are bonds and stocks both falling in price? Lately, bonds and stocks have sold-off and if the bullish view, that investors are relocating capital from bonds to stocks because they are optimistic about future US economic prospects is true then why the recent stock-mark sell-off too?

What then is the bearish view that rising yields trigger risk-off scenario?

One of the adverse impacts of the greatest monetary easing experiment in the history finance is that the trillions of dollars pumped into the financial system through the central bank’s bond purchase program, know as quantitative easing QE kept financial asset prices artificially inflated. But QE is now well in the rear mirror and it is the Fed’s transition to quantitative tightening QT that is taking the air out of all financial assets. So if QE fuelled the rally of everything then QT will result in the inverse, a fall in bonds and stocks, real estate.

Rising yields trigger risk-off scenario because risk on assets become unattractive when borrowing costs spiral. As the Fed unwinds its massive balance sheet that depresses bond prices which sends yields higher. But higher bond yields also raises the cost of servicing debt and that hits the bottom line of many highly leveraged companies.

So this view argues that investors will shun stocks which are by many matrices already in a bubble blown-up by years of the central bank’s QE. Moreover, as the Fed continues to hike its Fed fund rates that eventually results in higher mortgage repayments for households which is also a headwind on consumer spending.

What is now on every trader/investors mind is the threshold level when rising yields trigger risk-off

When the ten year US Treasury yield goes above 3.25% that would cement the trend of capital flows out of stocks and into bonds, according to billionaire Wall Street investor David Tepper.

“I think if they (Treasury 10 year yields) only go to 3.25% for the rest of the year then stocks might be up” – David Tepper.

US Treasury 10 year yields reached an all-time year high of 3.23% (October 5) that is more than double Spanish 10 yr at 1.57%. Put another way the market is saying that US T10 is more of a risky investment than Spanish T10? So reading between the lines that means that US T10 are oversold, investors are going to get wind of that and start piling capital into relatively low-risk US T10 and take the benefit of those high yields.

But if capital flows into US 10 year treasuries that will cause a dollar liquidity drought and send emerging markets and stock lower. So rising yields trigger risk-off view has validity. What is less clear is the motive behind this recent sell-off in US 10 year treasuries, is it investor optimism, or the Fed’s QT, or is it the result of US-China trade war. Has China, the largest foreign investor in US treasuries, decided to unload their trillion dollar treasuries position?

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