With US 10-year bond yields at a seven-year high, a relatively minor shock could be enough to trigger forced selling on equity markets, says FIIG.
The yield on 10-year US treasuries closed at 3.11 per cent overnight on Friday, a seven-year high that prompted speculation about a shift out of equities.
Speaking to InvestorDaily, FIIG NSW state manager Jon Sheridan said that if the 10-year holds at this level it will have broken the long-term secular downtrend in yields.
While he did not profess to be a “massive believer” in technical analysis, he said it is important to realise that many of the people trading in markets do.
And with high levels of margin debt and stretched valuations on the S&P 500 index, equity markets are looking like a “bit of a house of cards at the moment”, Mr Sheridan said.
“A strong gust, whatever that might be – it might be a geopolitical thing, or Facebook getting regulated, or Tesla raising capital – could break the fragile confidence,” he said.
“And then it all comes tumbling down and then you've got algorithmic selling, and margin debt being called and forced selling – all the waterfall effects that you don't want to see if you're an equity investor.”
There are three indicators that have Mr Sheridan worried about the future trajectory of the current US equity bull run.
First, the three-month US treasury bill is now above the yield on the S&P 500. In other words, he said, investors can get a higher (and risk-free) yield on three-month treasuries than they can get from the dividend yield of the stocks on the S&P 500.
Second, the 10-year treasury yield, at 3.11 per cent, is above the terminal US Federal Reserve funds rate of 2.75-3 per cent – something that has never happened before (at least “sustainably”).
"What that means is that if you think history will play out again, you should actually be a buyer of longer-dated bonds, because the chances are that yields aren't going any higher from here. And in fact may even go lower," Mr Sheridan said.
Finally, the spread between the US 10-year and 2-year yields has fallen to 51 basis points (down from 1 per cent a year ago, and from 2.62 per cent in December 2013).
When the spread goes negative (i.e, ‘inverts’) it means 2-year yields are higher than their 10-year counterparts.
“Every time since World War Two there has been a recession within 1 to 3 years from that inversion,” Mr Sheridan said.
“That's the main signalling influence that the yield curve has in terms of the general economic outlook, and of course recession is terrible for stocks and property, because they're risk-on assets,” he said.
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