The on-again-off-again ‘great rotation’ from bonds to money-markets to stocks has (so far) seen retail flood into stocks as the BTFATH mentality is rife. As BofAML notes, through soothing “word of mouth” intervention, Bernanke’s most important accomplishment over the past few weeks has been to significantly reduce the market’s perception of upside tail risk for longer term interest rates. But, they remain very concerned in the short term about the scenario of a more disorderly rotation out of high grade funds, where credit spreads widen in response to further increases in interest rates. In this case, institutional investors will ‘leave’ risk markets en masse (with no rotation to stocks) as unwinds occur en masse. For now, it appears a 3.5% 10Y rate is the line-in-the-sand for a ‘disordely’ rotation.
1) Great Rotation has started at retail level
2) Mainly from IG bonds to stocks (not HY which is seeing inflows again as ‘low-beta’ yieldy stocks)
3) Bernanke managed to keep a lid on rate expectations and calm markets back from the edge…
4) BUT – a disorderly ‘rotation’ remains the major concern
5) 40% of institutional investors see 3.5% 10Y as the line in the sand for ‘disorder’
6) Disorderly rotation is a retreat from risk markets entirely (rates not driven by growth but by unwinds) as its impact on credit spreads would then flow back into equities and make them considerably more expensive on any discounted cashflow basis.
7) Ball is in Bernanke’s court (and the FOMC is coming up soon).
Don’t worry, be happy
Through soothing “word of mouth” intervention, Fed Chairman Bernanke’s most important accomplishment over the past few weeks has been to significantly reduce the market’s perception of upside tail risk for longer term interest rates. Hence, interest rate volatility has declined by one third since the post payrolls highs.
He accomplished this by expressing surprise about the market reaction to the Fed putting tapering on the table for this year, as the increase in interest rates has overshot what was warranted by improving fundamentals and QE tapering talk (due to the unwind of leveraged positions). Moreover, Bernanke has made it clear that the Fed is not going to tolerate interest rates at levels that would threaten the housing/economic recovery.
For credit spreads this decline in upside tail risks is important, as we are still significantly below the 3.5% level on the 10-year that the typical high grade investor believes will trigger a disorderly rotation – i.e. wider credit spreads due to outflows – if reached over the next three months.
Thus, with investors becoming increasingly comfortable with credit spreads, we have seen a more orderly rotation over the past few weeks and credit spreads have retraced much of their rates induced widening.
Let’s rock and rotate
However, clearly the increase in rates has been sufficient to start the rotation out of bonds, into equities on the retail side. The most recent development has been the strong rebound to significant high yield inflows we saw this week. However, high grade bond funds are still experiencing outflows – especially when disregarding the consistent inflows to short term funds. Generally retail flowscurrently favor low quality – such as high yield and equities – over high quality – munis, high grade, EM.
Our baseline view is for gradually increasing interest rates and a continued orderly rotation out of high grade bond funds with tighter credit spreads, where institutional demand at more attractive yields more than makes up for mutual fund/ETF outflows. However this view is most useful for long investment horizons, as the risk-reward relation for a short term tactical long trade appears unattractive. We remain very concerned in the short term about the scenario of a more disorderly rotation out of high grade funds, where credit spreads widen in response to further increases in interest rates.
What keeps us up at night…
…is still interest rate risk. While, again, our baseline view is for an orderly rotation – and that assumes a rather gradual, linear increase in interest rates – clearly the next couple of years will be more challenging for high grade bonds than we have seen in environments with inflows. We are very concerned that interest rates will not increase gradually, but in bursts and overshoot at times. For example, despite the reduction in tail risks a near term more modest spike to 3.0% on the 10-year appears within the range of possible outcomes.
Such a move could lead to an acceleration of outflows from high grade mutual funds and ETFs, leading to wider credit spreads. Obviously, institutional demand may still keep spreads in check like presently – but unless Bernanke manages to keep a lid on interest rate volatility, despite the increase in interest rates, we think the risk is that institutional money moves to the sidelines (at least initially).