Yield rise in the bond market: the good, the bad and the ugly
An article by Michael Herzum
CFA, Head of Macro & Strategy
- Cross-asset implication: the cause and speed of the yield rise are key
- The current yield rise is in the ‘good’ scenario; speed is in the ‘bad’ scenario
The debate about inflation and the Fed’s tapering are keeping volatility high in 2021
The brake is being applied to risk assets such as equities, but they are not stalling
Strategy recommendation: still equities over bonds; greater tactical awareness required; cyclicals, value > defensives and transatlantic divergence
The bond markets remain in turmoil. Although the situation has temporarily eased , it remains precarious. The driving force is the US bond market, where yields on ten-year Treasuries have risen by 16 basis points in the month to date and now stand at 1.56 per cent. The increase is around 100 basis points since late summer and almost 70 basis points since the start of this year. Jerome Powell, Chair of the Federal Reserve, did nothing to stop the yield rise last week. The markets have been left to their own devices in the current blackout phase before the meeting of the Federal Open Market Committee (FOMC) on 17 March.
We want to look beyond the current market volatility to study the bigger picture in the capital markets. In late autumn 2020, we provided a constructive outlook for risk assets. Many of the predictions came to pass, and our positive predictions were often achieved or exceeded at the start of the year. We had also forecast a rise in bond yields, but the extent and speed of the increase have overshot our expectations by a long way. The key question is thus whether the yield rise in the bond markets calls our overall constructive picture into question.
The good and the ugly
The cause of the yield rise is key to assessing its effect on other risk assets, such as equities and credits. If bond yields are rising in anticipation of an improving economic outlook, the yield rise is benign. In this case, the higher bond yields will be accompanied by higher revenue and profit for companies. The favourites are currently switching between the growth and value styles. The brake is being applied to the equities asset class as a whole, but it is not stalling. The average historical correlation between changes in bond yields and share prices is therefore slightly positive. Both asset classes are reacting to the same event that is expected to happen in the future. In our view, the current yield rise is predominantly in this scenario (‘the good’). Yields are going up because the markets expect growth in the US to soon accelerate rapidly as the pandemic is brought control and the next US fiscal stimulus package is introduced. The latter will have a direct impact on demand due to its size (US$ 1.9 trillion or 9 per cent of GDP) and structure (stimulus cheques, boost to unemployment benefit, etc.). The yield rise is justified and therefore benign. If this growth scenario materialises, yields will climb even further over the course of the year (forecast for ten-year Treasuries at the end of the year: 1.90 per cent).
The yield rise will become malignant or ‘ugly’ only if it is accompanied by a persistently more gloomy outlook for inflation. In this (as yet) non-existent scenario, the central banks will be called upon to counteract this inflation uplift by tightening monetary policy. The yield rise in the bond market will then be driven by real rates of return, a situation that would be highly damaging to risk assets. Higher real bond yields and an increasingly uncertain outlook will then hit the equity markets particularly hard. The following chart shows the performance of the asset class (broken down by region and style), depending on the driver of the yield rise. As expected, higher real rates of return are particularly detrimental to growth, small caps and emerging markets. The last time that this was the case was in the second half of 2018, when a US economy running at full throttle pushed up core inflation to almost 2.5 per cent in the summer of that year. Following on from the six interest-rate hikes that it had already carried out, the Fed raised interest rates twice more before the end of 2018. The S&P 500 fell by almost 20 per cent in the period September to December.
Cross-asset implication of rising bond yields
Performance in the event of rising US bond yields; Differences depending on the driver of the yield rise: break-even (inflation) or real rates of return
In the US, inflation will briefly jump to almost 3 per cent in the second quarter of 2021. However, this is due to the extraordinary effects of the coronavirus pandemic rather than being a sign of sustained inflationary pressure. The cyclical inflationary forces are still not pronounced enough. The Fed will see through the brief increase in inflation, especially in view of the change of direction in its monetary policy last year, when it gave its price target a ‘memory’. Sustained phases of low inflation will enable the Fed to accept a brief but moderate rise in inflation above the target of 2 per cent. When he presented his semi-annual report to Congress on 24 February, Jerome Powell reiterated that the Fed will not raise interest rates until inflation has exceeded 2 per cent for some time ("We believe we can do it, we believe we will do it. It may take more than three years"). We are therefore not expecting an interest-rate hike from the Fed until late 2023/early 2024.
In this context, it is important to distinguish between the raising of key interest rates and the tapering of government bond purchases. We expect tapering to begin in the second quarter of 2022, with an announcement to be made towards the end of this year. The Fed will open this discussion no later than at the Jackson Hole Symposium in late summer. Nevertheless, a malignant yield rise does not look likely at the moment.
However, an overly fast yield rise also adversely affects risk sentiment and leads to higher cross-asset volatility. We have examined past phases of short, sharp yield rises. 40 basis points in 35 trading days is the pain threshold for the US equity market. At this speed, significantly below-average equity returns can be seen in subsequent weeks, particularly if the yield rise is predominantly achieved with higher real rates of return on bonds. This year, the critical threshold was reached back in mid-February. Moreover, real rates of return have been the main driver of yields since this point. The heightened volatility and weaker performance of share prices are therefore following the historical pattern. We believe that the uncertainty has also been fuelled by the very high risk appetite of investors. This year, our Cross-Asset Risk Appetite index (CARA) reached its highest level since 2006. Other familiar indicators, such as Bull-Bear, Risk-Love and the BoA fund manager survey, confirm the strong risk appetite of investors. Like us, many investors have already positioned themselves for the favourable capital market conditions.
Rapid yield rise in combination with historically high risk appetite
Critical threshold: 40bp within 35 trading days
What will ease or even resolve the situation?
In his speech last week, the Fed Chair dashed investors’ hopes of intervention to bring the yield rise under control. The Fed currently believes such a step would be premature, but will be an option if the yield rise casts doubt on the Fed’s targets. The next opportunity to ease the situation will be provided by the Fed’s projections at the FOMC meeting next week (17 March). For the first time since bond yields really took off, the Fed members will reveal their opinion on the future trajectory of interest rates. The ‘dots’ may potentially be brought forward slightly. After all, the US fiscal stimulus package is on the brink of being approved. Therefore, there is a good chance that the bond markets will stabilise and the yield rise will slow down a little.
Recommendations for asset allocation / investment strategy
Big picture: The brake is being applied to risk assets such as equities, but they are not stalling. An end to the bull market after less than a year would be unusual.
Asset allocation I: greater tactical awareness required. We have already moved on from the robust performance phase seen at the start of a bull market. From this point, the gradient of the rise of risk assets will be flatter, i.e. a tactical approach will become more important.
Asset allocation II: keep equities long / bond short positions. This allocation will help if the US output gap closes more quickly than expected and thus provides sustained momentum for inflation. A (supposedly) negative contribution from the overweighting of equities is offset by positive contributions from the underweighting of bonds (positive correlation of equity and bond performance).
Transatlantic divergence: The cyclical recovery in the US is starting earlier and more strongly than in the eurozone. The transatlantic spread therefore still has some leeway and the US dollar will benefit from a cyclical tailwind in the coming months.
Investment styles: Our preference for 2021 was and remains cyclicals > defensives. Large parts of the value style are gaining more leeway due to the confirmation provided by higher bond yields.
As at 9 March 2021