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    MARKET EDGES

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Takeaway: The seismic shift in interest rates will certainly be one of the most critical factors over the coming quarters and years.

(Editor's note: The excerpt below is from this morning's "Morning Newsletter." For more information on how you can become a subscriber, click here.)

The Queen Mary of macro trends has inflected– We often use the analogy of the Queen Mary turning to describe the long term trend in interest rates.   The Queen Mary, of course, is the massive ocean super liner that dominated transatlantic voyage before the jet age.  Like any vehicle that is more than 300 meters in length, turning the Queen Mary was no easy task and not without its implications.

The Queen Mary of Macro Trends - 10Y Treasury

This analogy is appropriate for interest rates as they have literally been in decline for the last 30 years since peaking in the early 1980s.  This long term decline has enabled any business that depends on borrowing money to fund its business to have a steadily declining cost of capital.  In addition, this has made bonds a compelling asset class with a long term underlying bid to price.

In our models in Q2, yields inflected notably and broke out above our TRADE, TREND and TAIL levels.  In fact, as shown in the Chart of the Day, 10-year yields had their largest percentage increase quarter-over-quarter in more than a decade.  Even though 10-year yields have broken out, they remain well below the mean yield since 1989 of 5.21%.

As volatility in an asset class increases, so too does the expected loss and/or return.   According to Merrill Lynch’s MOVE index, bond volatility has almost doubled in the last quarter and is at two year highs.  Meanwhile duration is at close to all-time highs.  My colleague Jonathan Casteleyn of our financials team highlighted this in his recent presentation on asset managers (ping sales@hedgeye.com if you haven’t seen it yet), but based on current duration a roughly 100 basis point move in yields equates to a 8.9% loss on the 10-year treasury.

In part we are already starting to see the sort of generational losses in bonds that we should expect from the dynamics outlined above.  Specifically, the Barclay’s Aggregate Bond Index is set for its first loss in 14-years and only third loss since 1990.  While gentleman may prefer bonds, they don’t prefer losses.

The reality in markets is that there is rarely "One Thing" that dominates, but the seismic shift in interest rates will certainly be one of the most critical factors over the coming quarters and years.  As money flows from the bond market to avoid losses, equities will be awaiting with open arms.