On the global strategy team we can see the 10 year potentially rising to 1.8-2% based on: an extreme gap between ISM and bond yields, the risk that US GDP is c7-8% rather than consensus of c5% on the back of fiscal packages, c$9.3trn in real wealth generated since Jan 20 and $1.5trn of excess savings - thus we could see the output gap closing in Q4. We see inflation expectations rising to 2.5%-3% eventually (from c.2.15% currently), see Inflation – the big issue, Jan 29, with prices paid suggesting a sharp rise in core PCE and wage growth starting to rise; and the Fed only buying a third of net issuance.

What caps the rise in yields: i) a limited rise in European or JGB yields and an increasingly attractive (currency hedged) yield pick-up in US yields; ii) the Fed may use forward guidance to cap rates (we think it will not want to see that much of a rise with the average maturity of mortgage debt more than 10 years and IG debt c9 years, thus 1% on yield could take 1.5% to 2% off GDP growth). Critically, we see most of the move higher being driven by inflation expectations.

What is problem level for equities? Around 2% for the 10y UST, in our view. Historically, equities have been able to accommodate an average 130bp rise in rates with 170bps seen in 08/09. Higher rates hurt equities via valuation, interest charge, growth and funds flow. We don’t see rising inflation expectations as a problem until the Fed meets its target (probably around core CPI of c2.8%) and historically equities have not de-rated until inflation is above 3%. The key driver of multiples in the past 5 years has been the TIPS yield (prior to that it was not).

Regions: Japan is the biggest winner from the rise in nominal yields or TIPs. GEM is most vulnerable though with their basic balance of payments at a 15 year high they are much less vulnerable than during the taper tantrum. The US is now more vulnerable to a rise in TIPS given its high exposure to long duration assets. Italy & Spain have been the best-performing countries when yields rise, Switzerland and the US the worst.

Sectors: Unsurprisingly, real estate, utilities, and beverages have the most negative correlation to rising bond yields. Banks, diversified financials, and autos the most positive. Higher yields are pro-cyclical, but we keep to our benchmark of non-financials because they are pricing in a PMI in the low 70s (5.5% European GDP) and we have had the equal-largest cyclical rally on record. In the past 2 years US tech has been very driven by the TIPS yield (a rise leads to long duration assets underperforming). We add to our overweight of banks (we have 22% upside on our model, more so on our year-end forecasts), add to life companies and further reduce the sizes of our tech (ex-semis) and utilities overweights.

Stocks: We look at the stocks most positively correlated to rising bond yields and Outperform rated by our analysts, including ING, Lloyds, AXA, BASF and Randstad. Stocks with high debt to market cap (with poor FCF) and are negatively correlated to bond yields include UU, ABI and Italgas.