BRASILIA, July 22 (Reuters) – Brazilian fixed-income markets are pricing in the highest risk levels in years, raising red flags among investors and government officials who see little relief in sight.While global interest rate hikes and recession risks have put all emerging markets under pressure, Brazil faces special scrutiny after Congress cracked open a constitutional spending cap to allow a burst of election-year expenditures. read more “The problem is the change in the spending cap,” said an Economy Ministry official, who requested anonymity to discuss the situation openly. “It weakens the reading that the fiscal situation will be under control in the coming years.”Register now for FREE unlimited access to Reuters.comEven with positive surprises such as strong June tax revenue data on Thursday, the official said Brazil’s yield curve remains under pressure as investors brace for the worst. read more Both major presidential candidates on the ballot in October – leftist former President Luiz Inacio Lula da Silva and right-wing incumbent Jair Bolsonaro – have signaled they plan to extend this year’s boost in social spending into next year.”It’s a fiscal bomb,” said Sergio Goldenstein, chief strategist at Renascença DTVM. “Risk premiums look high, but there is little room for a relevant drop.”The real rate for inflation-linked government bonds has been running at the highest level since late 2016, while Brazil’s five-year credit default swaps are at highs last seen at the beginning of the pandemic in March 2020.Concerns about Brazil’s credit profile come as commodity shocks from the war in Ukraine rattle the global economy and contribute to inflation, prompting rich nations to start raising interest rates.”All the credit spreads in the world are opening, our bonds are not immune to that,” said Ronaldo Patah, chief strategist at UBS Consenso.In fact, Brazil’s strong exports of grains, oil and iron ore give it some advantages compared to other emerging markets riding out the current surge in commodity prices, independent of the political risks in Brasilia now rattling investors.Brazil’s central bank also got an early start hiking rates compared to most peers, raising its benchmark interest rate from a record low 2% in March 2021 to 13.25% currently, with another hike penciled in for August to curb double-digit inflation.Most of the market has therefore been betting on rate cuts supporting growth from the middle of next year. However, risk premiums now point to rates above 13% in the yield curve for maturities ranging from 2024 to 2033, while mid-2023 vertices indicate an accumulated rate above 14%.”I am struck by this process of (yield curve) flattening that we are seeing at a very high level”, said the chief economist at Ativa Investimentos Etore Sanchez.Roberto Dumas, chief strategist at Banco Voiter, said Brazil is caught between a central bank tightening rates while the government is finding new ways to boost spending.”The more one accelerates, the more the other needs to step on the brakes. Everyone is projecting more and more that the Selic will rise more than expected”, said Dumas, who foresees the benchmark rate at 14.25% at the end of this year.Register now for FREE unlimited access to Reuters.comReporting by Marcela Ayres and Jose de Castro
Editing by Brad HaynesOur Standards: The Thomson Reuters Trust Principles. .
Reuters GraphicsOn Tuesday, stocks shrugged off the rise in yields, with the S&P 500 ending up 1.6% on the day. Still, the S&P 500 is down 6.4% this year, while the yield on the 10-year TIPS has climbed more than 100 basis points.”Real 10-year yields are the risk-free alternative to owning stocks,” said Barry Bannister, chief equity strategist at Stifel. “As real yield rises, at the margin it makes stocks less attractive.”One key factor influenced by yields is the equity risk premium, which measures how much investors expect to be compensated for owning stocks over government bonds.Rising yields have helped result in the measure standing at its lowest level since 2010, Truist Advisory Services said in a note last week.
Reuters GraphicsHEADWIND TO GROWTH SHARESHigher yields in particular dull the allure of companies in technology and other high-growth sectors, with those companies’ cash flows often more weighted in the future and diminished when discounted at higher rates.That may be bad news for the broader market. The heavy presence of tech and other growth stocks in the S&P 500 means the index’s overall expected dividends are weighted in the future at close to their highest level ever, according to BofA Global Research. Five massive, high-growth stocks, for example, now make up 22% of the weight of the S&P 500.At the same time, growth shares in recent years have been highly linked to the movement of real yields.Since 2018, a ratio comparing the performance of the Russell 1000 growth index (.RLG) to its counterpart for value stocks (.RLV) – whose cash flows are more near-term – has had a negative 96% correlation with 10-year real rates, meaning they tend to move in opposite directions from growth stocks, according to Ohsung Kwon, a U.S. equity strategist at BofA Global Research.Rising yields are “a bigger headwind to equities than (they have) been in history,” he said.
Top five stocks market cap as percentage of S&P 500Bannister estimates the S&P 500 could retest its lows of the year, which included a drop in March of 13% from the index’s record high, should the yield on the 10-year TIPS rise to 0.75% and the earnings outlook – a key component of the risk premium – remain unchanged.Lofty valuations also make stocks vulnerable if yields continue rising. Though the tumble in stocks has moderated valuations this year, the S&P 500 still trades at about 19 times forward earnings estimates, compared with a long-term average of 15.5, according to Refinitiv Datastream.“Valuations aren’t great on stocks right now. That means that capital may look at other alternatives to stocks as they become more competitive,” said Matthew Miskin, co-chief investment strategist at John Hancock Investment Management.Still, some investors believe stocks can survive just fine with rising real yields, for now. Real yields were mostly in positive territory over the past decade and ranged as high as 1.17% while the S&P 500 has climbed over 200%.JPMorgan strategists earlier this month estimated that equities could cope with 200 basis points of real yield increases. They advised clients maintain a large equity versus bond overweight.”If bond yield rises continue, they could eventually become a problem for equities,” the bank’s strategists said. “But we believe current real bond yields at around zero are not high enough to materially challenge equities.”Register now for FREE unlimited access to Reuters.com
US ‘term premium’ stays negative
Fed contrast between Yield Curve and Near Term Forward SpreadBUMP IN THE NIGHTSo what’s the beef with the term premium?In effect, the Treasury term premium is meant to measure the additional yield demanded by investors for buying and holding a 10-year bond to maturity as opposed to buying a one year bond and rolling it over for 10 years with a new coupon.In theory it covers all the things that might go bump in the night over a decade hence – including the outside chance of credit or even political risk – but it mostly reflects uncertainty about future Fed rates and inflation expectations.At zero, you’d assume investors are indifferent to holding the 10-year today as opposed to rolling 10 one-year notes.But the New York Fed’s measure of the 10-year term premium remains deeply negative to the tune of -32 basis points – ostensibly suggesting investors actually prefer holding the longer-duration asset.Although the premium popped back positive in the first half of last year, it’s been stuck around zero or below since 2017 – oddly in the face of the Fed’s last attempt to unwind its balance sheet.And the persistent and puzzling erosion of the term premium to zero and below brings it back to the 1960s, not the much-vaunted inflation-ravaged 1970s that everyone seems to think we’re back in.It matters a lot now as the debate about the inversion of the 2-10 yield curve heats up and many argue that the signal sent by that inversion is less clear about a coming recession as it’s distorted by the disappearance of the term premium.In the absence of a term premium, the long-term yield curve is just a reflection of long-run policy rate expectations that will inevitably see some retreat if the Fed is successful in taming inflation over the next two years.Fed Board economists Eric Engstrom and Steven Sharpe late last week also dismissed the market’s obsession with a 2-10 year yield inversion signalling recession.In a blog called ‘(Don’t Fear) The Yield Curve’ they said near term forward rate spreads out to 18 months were much more informative about the chance of a looming recession, just as accurate over time and – significantly – heading in the opposite direction right now.The main reason they pushed back on the 2-10s was it contained a whole host of information about the world beyond two years that’s simply less reliable as an economic signal and “buffeted by other significant factors such as risk premiums on long-term bonds.”But what could see the term premium return?Presumably the Fed’s planned balance sheet rundown, or quantitative tightening (QT), would be a prime candidate if indeed its long-term bond buying has distorted term premia.But the last Fed attempt at QT in 2017-19 didn’t do that and Morgan Stanley thinks it will be some time yet before just allowing short-term bonds on its balance sheet to roll off and mature gets replaced by outright sales of longer-term bonds.”QT is not the opposite of QE; asset sales are.”Of course, maybe the world just hasn’t changed that much – in terms of ageing demographics, excess savings and pension fund demand, falling potential growth and negative real interest rates. Once this current storm has passed, investors seem to think that will dominate once more. read more 
Fed balance sheet and maturitiesThe author is editor-at-large for finance and markets at Reuters News. Any views expressed here are his ownRegister now for FREE unlimited access to Reuters.com
FEDFor Kelsey Berro, fixed income portfolio manager at J.P. Morgan Asset Management, the level of yields in overseas markets such as Japan or Germany have made U.S. rates comparably more attractive, preventing a sustainable sell off, but that is expected to change.”Already you should start to see that some of these foreign investors take a second look at their home countries rather than reaching for yields in the U.S.,” she said.Still, there was strong demand seen for a recent 10-year Treasury auction, although it was unclear how much overseas bidders participated. SPEEDY ASCENTThe rise in US yields has come faster than many anticipated: In December, a Reuters poll forecast that 10-year note yields would rise to around 2% towards the end of 2022 – a level it has reached in the first couple of months. read more Some banks have been updating that view. Goldman Sachs analysts on Wednesday raised their forecast for the U.S. 10-year Treasury yield to 2.25% by end-2022, from a previous year-end target of 2%.The pace of gains has caused volatility in other assets. U.S. equities have been rocky this year, with shares of tech companies particularly volatile, as expectations of higher yields threaten to erode the value of their future earnings.Gene Podkaminer, Head of Research for Franklin Templeton Investment Solutions, called 2% on the benchmark 10-year a “psychological” level that could make U.S. government bonds more attractive versus other assets, such as volatile stocks.”When you start getting close to 2% … all of a sudden Treasuries are looking more appealing,” Podkaminer said earlier this week.One commonly cited metric still favors stocks, however.The equity risk premium – or the extra return investors receive for holding stocks over risk-free government bonds – favors equities over the next year, Keith Lerner, co-chief investment officer at Truist Advisory Services, said on Wednesday.The S&P 500 has historically beaten the one-year return for the 10-year Treasury note by an average of 11.8% when the premium stood at Wednesday’s level of 260 points, Lerner said.“I don’t think the U.S. 10-year yield hitting 2% would have a big impact on the stock markets per se,” said Manish Kabra, head of U.S. equity strategy at Societe Generale, citing the equity risk premium.However, “we could see some pressure if yields go to 2.5%,” she said.Register now for FREE unlimited access to Reuters.com