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What Drives the Market Risk Multiple? The Yield Curve


We're witnessing a tug of war between the Fed fighting deflationary pressure and the risk markets needing a flattening curve.

I am a big believer in the impact of sentiment on market dynamics. Over the past couple of weeks, we have seen some major capitulation among Wall Street strategists. Bank of America Merrill Lynch (NYSE:BAC), or BAML, has the largest network of retail financial advisors, and so when their strategists make a big forecast adjustment, it's worth noting as a gauge of potential retail investor sentiment.

After the better-than-expected June employment report, BAML rates strategist Priya Misra issued a revision to her interest rate forecast, raising the year-end 10-year target from 2.4% to 3.0%. On the surface, this target revision would not be that notable. But when I saw the headline, I immediately thought it was a capitulation.

Misra has been very bullish on bond prices predicated on slowing growth and consumption. Just back on May 13, with the 10-year approaching 2.0%, she reiterated her bullish view.

The recent sell-off has been puzzling since the only recent positive economic data of note was the April payroll report. Even though payrolls were better than expectations, it was not clear that we are out of the woods yet.... It is difficult to justify both higher real rates and lower inflation expectations than earlier this year from just a repricing of growth expectations.

Ultimately, fundamentals and Fed policy drive rates. Notwithstanding the payroll report, growth data in general has been a bit weak, in our view.... Thus, we recommend owning Treasuries, looking for the 10-year to drift back toward 1.75% in the next month.

Then, two weeks later, obviously burned by the intense mortgage-backed security (MBS) convexity blowout underway, she backed off from her bullish call and moved to 2.4%. Thus in reality, her target raise on July 5 wasn't from just 2.40% to 3.0%; she basically moved from 1.75% to 3.0% in less than two months, with no material change in fundamentals. In fact, you could certainly argue that her economic forecast has been spot on and that she just got caught by a carry trade blowup. Her rationale (emphasis my own):

The June FOMC meeting where the statement, projections, and the Chairman's press conference were hawkish relative to expectations, indicated a different Fed reaction function. The market perceives the Fed to have a lower threshold for tapering.

Labor market and housing data -- the most cited indicators from the Chairman's June FOMC press conference in June -- have continued to strengthen. Further, the outlook remains positive as downside risks have receded.

Apart from the fundamental shift above, technical factors continue to be key, and will be a headwind for the rates market. The new highs in rates should keep MBS convexity risks high. Given continued underperformance of bond fund indices, fund outflows should continue. This can continue to put pressure on Treasury rates as investors will look to hedge fixed income duration risks using Treasuries.

This past week, BAML's equity strategist Savita Subramanian followed up with a huge upgrade of her 2013 year-end S&P 500 (INDEXSP:.INX) target, moving from 1600 to 1750. This 150-handle change isn't just a calibration; she is changing the model (emphasis my own).

Our new S&P 500 target of 1750 for 2013 is principally based on our fair value model, but if the last several years have taught us anything, it is that fundamentals sometimes take a backseat to sentiment, technicals, and macro.

The equity rally over the last eight months has been primarily driven by multiple expansion, with the forward PE multiple on the S&P 500 expanding from 12x to 14x (18%). In our fair value model, we focus on the normalized forward PE multiple, which has also risen from 13.5x to 16.0x (18%). This multiple expansion has predominantly been a function of the significant decline in the equity risk premium (ERP), partially offset by a modest rise in real normalized interest rates. While current real normalized rates are only modestly higher than our previous year-end assumption of 1.0% (now forecasting 1.5%), the 135bp drop in the ERP is more than double the 50bp that we had originally assumed going into the year.

But at 500bp, the ERP is currently still well above the sub-400bp levels preceding the financial crisis, and we think it should continue to decline over the next several years as the memory of the financial crisis fades, corporate profits continue to make new highs, and some of the macro risks abate. We expect the "wall of worry" to persist as new concerns emerge, but visibility is clearly improving and we still expect global growth to pick up as the year progresses. As such, we have lowered our normalized risk premium assumption in our fair value model for the end of 2013 from 600bp to 475bp, which assumes roughly another 25bp of ERP contraction by year-end.

So with the market up 18% on the year on the back of 100% multiple expansion, BAML is raising its price target by nearly 10% on the premise that we shall get further multiple expansion because fundamentals have taken a backseat to technical and sentiment. You can't make this stuff up.

These two major price target revisions by the Street's biggest retail brokerage firm in the two most important asset classes within weeks of each other cannot be a coincidence. I think this capitulation reeks of a management shoulder tap. Research doesn't like to be on the wrong side of the market for too long because it screws up their track record. These two dramatic price target adjustments could be an attempt to get back in line with the market.
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