Yields remain the dominant driver in our Macro Regime Classification (MRC) model, with the 3-month yield, 10-year yield, and yield curve slope carrying significantly more explanatory power than any other macro variable. The economy remains in a normal expansion, and any regime shift would most likely be triggered by a meaningful move in yields. While current probabilities of a regime change remain low, higher 10-year yields could tighten financial conditions wand weigh on stocks
From an equity perspective, implied equity duration (HERE) indicates Techn and other Early Cyclicals have the greatest sensitivity to yields, while Financials remain relatively low-duration and less sensitive. In line with this framework, the correlation between the 10-year yields and Early Cyclical relative performance has turned negative, implying higher yields would weigh more heavily on growth-oriented sectors than on Defensives. Though we expect 10yr yields to stay around 4.2-4.5%, rising yields would be more of a risk to Early Cyclicals.
What could move yields higher? Inflation remains the key driver of Fed policy and bond yields. Value factors are most positively correlated with core inflation, while Price Momentum is negatively correlated. Apparent easing of US–Iran tensions pushed oil prices and inflation expectations lower, contributing to a momentum rebound last week.
Meanwhile, Low Debt Cost Sensitivity stocks have consistently outperformed High Debt Cost Sensitivity stocks across both high- and low-economic-sensitivity cohorts, suggesting that debt-cost exposure remains an important and independent source of factor performance if yields move higher.
How to Sidestep Rate Risk Headwinds: Yields currently play a determinant role in our Macro Regime Classification (MRC) model. The 3-month and 10-year yields, together with the slope of the yield curve, carry feature importance that far exceeds any other macro variable. With the normal expansion continuing (HERE), any move away from the current regime would likely be yield-driven. At present, the probability of such a shift remains low.
Our investor survey indicates a 5% level on the 10yr yield would be enough to drive demand destruction (HERE). The scenario analysis on our Macro Regime Model points to a comparable tipping point: a Y/Y change of 5.1pp or more in the 10yr yield would shift the economy out of the current normal expansion regime, assuming all other macro components are unchanged. A recession regime remains unlikely even with a significant hike in yields; however, rising rate and tightening financial conditions will build enough momentum to cause meaningful market disruption.
According to implied equity duration (HERE), a framework which helps us quantify rate risk of equities based on investors’ consensus expectations, as reflected in stock prices, rather than forecasts of future cash flows. Similar to bond duration, higher equity duration suggests greater sensitivity to rates. Currently Early Cyclicals, especially Technology has the highest duration across the S&P sectors as growth names are more sensitive to yields. Financials, the sector most Value exposed, has relatively low equity duration.
That is in line with 10yr yield correlations with the relative performance of Early Cyclicals/Defensives, which is currently negative, suggesting higher 10yr yields will put more downward pressure on Early Cyclicals than Defensives. Though we are expecting 10yr yields to stay around 4.2 -4.5%, rising 10yr yield is a risk more to Early Cyclicals.
For now inflation remains the main focus of Fed policy makers and 10yr moves. Value factors are currently the most positively correlated with US core inflation, while Price Momentum exhibits the most negative correlation. Last week positive news on the Strait of Hormuz led to a Momentum reversal as inflation expectation and oil prices moved lower.
As US–Iran tensions eases, the High Economic Sensitivity basket generated negative returns while the Low Economic Sensitivity basket generated positive returns, suggesting expectations of slower future economic growth. The more important signal, however, lies within each economic-sensitivity cohort. Among the two High Economic Sensitivity baskets, Low Debt Cost Sensitivity outperformed High Debt Cost Sensitivity on both a short-term (WoW) and a medium-term (YTD) basis. The same held within the two Low Economic Sensitivity baskets, where Low Debt Cost Sensitivity again outperformed on both WoW and YTD horizons. In other words, after controlling for economic sensitivity, Low Debt Cost Sensitivity outperformed High Debt Cost Sensitivity across every dimension. This points to a durable, additive source of alpha: as long as a higher 10-year remains a headwind to the Debt Cost Sensitivity factor, the tilt is likely to pay off regardless of the prevailing macro or geopolitical outlook.
