High Fliers Living At The Mercy Of Real Yield

At this point, everybody knew equity markets didn't react well to the fast-rising 10-year treasury yield (1.57%). However, there are a lot of nuances beneath it. Things started to turn sour only after February 12. Before that, the inflation expectation (pink line) drove the 10Y nominal yield higher while the 10Y real yield (yellow line, inverted) stayed low and stable around -100bps. That set-up was the best environment risky assets could ever expect: economic activities are priced to pick up while financial conditions remain accommodative. Equities (white line, Nasdaq 100, for example) reached record highs as a result.

For many reasons, probably both technicals (mortgage negative convexity hedging and foreign investors selling) and fundamentals ($1.9 trillion fiscal stimulus, a slew of better than expected economic data, etc.), 10Y nominal yield kept going higher quickly after February 12. Unlike the prior dynamics discussed above, the 10Y real yield led the way up (from -100bps to -60bps) this time around. No matter how hard the Fed Chairman Jerome Powell tried to position it differently, the fast-rising real yield tightened the financial condition, precisely killing the expensive hyper-growth stocks. Why? Two reasons: a) a higher real yield provides less valuation multiple support; b) long-duration assets (such as hyper-growth stocks whose value is more determined by the terminal value) are more vulnerable to rising real yield.

In our opinion, risky assets are still in the process of re-pricing due to the change of real yield, and they need to get comfortable with a new reality. Understanding the path of the real yield as we advance is the key. That's why the coming FOMC meeting is crucial.