The Rate Rally… and the Trade to Follow

• A massive rate rally… 
• Is this the start of the (inevitable) normalization with rates?
• Banks, energy and healthcare (not tech) to move the market next

Rate are going higher and the long-term lows are in.

That’s my thinking.

But I could be wrong..

So why are they going higher?

Well three reasons come to mind: 

• Massive fiscal deficits via further stimulus measures;
• A potential COVID-19 vaccine; and/or
• An improving economy (as a result of the above)

Each of these are possible enablers of higher rates… irrespective of what the Fed does (or doesn’t do) at the short-end. 

Let’s start with what the move we see in US 10-year yields: 

US 10-Year Yield – Nov 10 2020

Whilst it may not look like much – yields on the 10-year have moved from a low 31.8 basis points (ie. 0.318%) to trade at 97.3 basis points (ie 0.973%) at the time of writing. 

That’s a huge move in a short space of time. 

This is what it looks like using the daily chart: 

US 10-Year Yields Continue to Rally

As I said in a recent post – keep your eye on this move – as we could be about to break significant higher. 

And this is going to have major implications across various asset sectors. 

Yield Curve Steepens – Good for Banks

With the yields on the 10-year now pushing 100 basis points – this has caused the yield curve to the steepen to its highest level in 3 years. 

For example, below is the spread between the US 10-year and 2-year treasury yield:

US 10-Year Treasury Yield less 2-Year Yield

Now as we know – a steep yield curve is very good for banks. 

Bank’s business model is to “buy short and lend long”. Therefore, the greater the spread, the greater their margin. 

Now take a look at the KBW Bank Index ETF over this same period (from 2012 to 2020)

KBW Bank Index ETF – 2012 to 2020

What’s noteworthy here is what we see post 2018… 

Over the past couple of years – the yield curve began to compress – putting a lot of pressure on bank stocks. 

However, over the past few months, they have begun to catch a bid as yields improved. 

And whilst banks stand to benefit from higher rates…  it’s a different story for tech.

Tech Stocks Don’t Want Higher Rates

Tech stocks are under pressure. 

Not only are we seeing the rotation into value (more in my conclusion) – the market is also wary on things like

(a) excessive tech valuations (with fwd PE’s well above 30x);
(b) impact of higher rates; and 
(c) the constant overhand of greater government regulation

It feels like it might be the perfect near-term storm for the sector. 

There is a clear link between the performance of technology stocks and the performance of bonds.

Tech stocks all tend to benefit from falling bond yields.

For example, check out this chart from Bloomberg which shows how bonds have increasingly dominated the price-to-book multiples of these names: 

Bloomberg highlight the fact there is an overlap between bond sensitivity and industrial sectors.

For example, banks prefer higher bond yields, and tech prefers them to be lower. 

With that, let’s start with the QQQ ETF

QQQ – Nov 10 2020

This popular ETF is now down 4% this week – as stocks such as Amazon and Microsoft were hit hard. 

Now 40% of this ETF comprises Microsoft, Amazon, Google and Apple.

This is the essence of the rotation into value

From here, I would expect the ETF to push down towards the 35-week EMA – which is a little over 9% lower from today’s close 

And if you can pick up the QQQ in the zone of $240 to $250 – I think it will represent a good long-term bet. 

The word of the week is “rotation” 

For example, it’s been a rotation from “stay at home” stocks to those which benefit from an economy re-opening. 

But if you ask me – the move has been excessive and potentially a little premature.  

Below is a chart courtesy of CNBC which dimensions some of the moves we have seen between cyclicals on the left and tech on the right. 

Moves of 10% plus in two days across sectors like energy, banks and industrials has been incredible. 

I personally can’t remember a rotation as swift in 20+ years of trading. 

Now the question I have is whether it sticks?

For example, is this trading or is this a theme that will follow through in the months ahead?

No-one knows that answer to that of course – but we do know that “one hot night doesn’t make a summer”

Yes – the news of a potential vaccine is very positive.

And yes – I think rates are on the move higher (at long last)

But even if we assume a vaccine can be widely distributed at scale as soon as Q2 2021 – the recovery will remain gradual. 

There are still many unanswered (vaccine) questions where far more data is needed. 

In closing, I continue to like tech for the long-term – but expect near-term selling pressure. 

Regards,
Adrian Tout