Help, the economy is recovering!

At the end of February, on the eve of the adoption of a third US stimulus package of unprecedented size, US 10-year yields have returned to their pre-pandemic levels of around 1.5%. Is this good news? Not for equities, and the Nasdaq in particular, which are retreating on the back of this development.

But shouldn’t markets be celebrating this normalisation? At last, rates that compensate the lender and not the borrower! At last, an incentive to spend rather than to save even more!

Fine line between reflation and inflation

Of course, there will be a tightening in financial conditions as the rise in long rates is passed on to the real economy. But we are right at the start of this phase of the cycle. In the absence of further lockdowns, the momentum of the recovery is such that it should be able to absorb a modest rise in rates. And more especially, since a slight rise in inflation, or reflation, is anticipated, specifically in the US, as a result of the new stimulus package. Restrained reflation would allow real rates, i.e. nominal rates less inflation, to remain minimal, if not negative. This would be an ideal situation in financial terms: positive nominal rates and minimal real rates have a beneficial impact on economic activity.

It’s true that there’s a fine line between beneficial reflation and destructive inflation, and this may explain the tension in the market. But for the last ten years, inflation in developed countries has been too low, particularly in Japan and Europe. Why would it suddenly explode when nothing has fundamentally changed in the economic system?

Does the nervousness on the markets testify to an imminent trend reversal?

So there must be another way to explain the market’s agitation. Specifically, by the fear that nominal rates are overreacting, particularly in an environment where governments are flooding the market with debt in order to mop up their deficits. But central banks have proven on many occasions that they have rates firmly under control. There is no doubt that they would absorb any excess of debt supply if necessary: in the words of Italy’s new Prime Minister and “saviour of the euro”, they are willing to do “whatever it takes”.

The final explanation could be specific fears about the future of stocks with the highest valuation levels, in particular innovative companies in the digital and energy sectors. Their current prices can only be justified by optimistic long-term assumptions. A structural increase in the cost of capital would take a heavy toll on their valuations and make them vulnerable. Any reversal in their fortunes would be brutal. As an example, Tesla lost 20% in February, in a perfectly correlated inverse relationship to US 10-year rates. But although this risk is more than simply anecdotal, it remains localised. Astute fund managers will be able to separate the wheat from the chaff. On the other hand, the advantages for the rest of the economy are considerable.

Finally, it’s an easy choice: let rates rise! (Sorry, Elon Musk!) During a period of economic recovery, equity markets as a whole should be able to cope with this. And eventually, bond markets may even become appealing again. Could we hope for any better news for stock markets?