The past month has had some volatility as investors mulled signs of irrational exuberance in various segments of financial markets. Once some of these deflated, equities were quick to make a comeback on a strong earnings season, though the recent surge in bond yields have raised another round of concerns.
Bond sold off as yields surged in the past month, with the Australian 10-year yield up nearly 0.5% to around 1.55%. The U.S. 10-year yield sits close to 1.4% after rising nearly 0.3%. A rise in bond yields is consistent with the expected economic recovery, but a surge higher would likely cause worries for equities with valuations running high.
Equities were largely higher over the past four weeks, shrugging off a sell-off in late January. The NASDAQ regained leadership, sporting a 6.6% rise over the past four weeks at the time of writing, whilst the S&P 500 was up 3%. Emerging markets were also a strong performer, with the Chinese CSI 300 index up 4.5%. The S&P/ASX 200 was a laggard, up just 0.5% in the same period despite a good reporting season thus far.
Cyclical commodities continue to rally, with Brent crude prices soaring with U.S. $65 in touching distance as weather issues disrupt production in the U.S. and optimism around a return to normal economic conditions. Iron ore prices have held up above U.S. $150, and copper continues to rise. On the other hand, gold has had a difficult time, falling to U.S. $1,770 per ounce.
The Australian Dollar has risen marginally to 77.6 U.S. cents.
Signs of improvement continue for Australia. Consumer sentiment has been strong alongside improving business confidence and elevated business conditions. Rising job advertisements signal a further rebound in employment ahead, with job gains continuing as Australia’s unemployment ratet fell to 6.4%.
Despite the improving backdrop, the Reserve Bank of Australia (RBA) doubled down on its quantitative easing (QE) program, adding $100 billion to the program to extend it from April to October. From its comments around QE becoming a relative game due to the likely impacts on the Australian Dollar, it now seems likely that further rounds of QE will be added in order to extend the program well into 2022 as other central banks are likely to continue their own QE programs beyond this year.
In the U.S., another round of stimulus talks remains ongoing, with the $1.9T package still going through the various levels of approval, with the target of trying to get the package through by mid-March, when the last round of unemployment stimulus is due to end.
The U.S. economic recovery has been mixed over the past couple of months due to the spike in new cases and restrictions at the end of 2020 and start of 2021. Activity indicators remain strong for both manufacturing and services sectors, but the employment recovery has been adrift for several months now, rising just 49,000 in January. The last round of stimulus can be seen working its way through to spending though, as U.S. retail sales surged strongly with an impressive 5.3% growth between December and January.
Elsewhere, European activity indicators continued the trend of resilient manufacturing and weak services, whilst the recent growth in new cases in China and tighter liquidity conditions have fed through to weaker than expected activity indicators for both services and manufacturing, though both remain firmly in expansionary territory.
Progress on the vaccine front has been promising. As rollouts in the U.S., U.K. and Europe accelerate, there has been a marked slowdown in new cases and hospitalisations. With this comes the hope that a return to normal can be achieved by the middle of the year. This is something that markets will be watching closely.
Surging yields poses risks
COVID-19 brought along a collapse in yields, driven by the economic slowdown and markedly lower inflation expectations. Central banks acted quickly, slashing rates and ramping up QE programs to bring both short and long term borrowing costs down. Not long after, governments globally committed to significant fiscal stimulus, throwing large swathes of cash at the problem in hopes driving a strong post-pandemic recovery after self-imposed lockdowns. This resulted in inflation expectations swinging back upward, with inflation expectations and other indicators recovering gradually, before vaccine news sent them flying.
Whilst bond yields have risen at an orderly rate until recently, real yields, which are bond yields adjusted for inflation expectations, have been driven deeper into negative territory as inflation expectations rose. Forward looking indicators are pointing towards a further rise in inflation expectations.
This should drive bond yields higher but global central banks are cognisant of the issues this could pose to the nascent and still fragile recovery. Higher bond yields leads to higher borrowing costs which could impact both business conditions and consumer sentiment so central banks have continued to emphasize QE, lower for longer cash rates, and the likelihood that this inflation impulse will be transient. This has kept yields rising at a lower pace than many historical indicators suggest.
Regardless, central banks can only do so much and have been able to keep near-term rates close to the official cash rates, but longer term rates are rising. In the first weekly newsletter that I wrote for 2021 in early January, I referenced this as a risk to markets. An orderly rate rise would likely be a positive for markets, but any surge over 1.5% for the U.S. 10-year could prove a challenge across the board.
Firstly, we take a look at fixed income. For traditional government bonds, it is pretty simple, as yields push higher, investors suffer losses on their capital value as bonds get marked to market. With yields coming off a low base, there is little cushion provided by coupons, and longer dated bonds suffer more than short-term ones.
On the credit side, the chart below shows that credit spreads across the universe have largely compressed to pre-COVID levels.
This means that there is little room for further capital increase from a tightening credit spread. Even floating rate securities tend to have the variable portion anchored to the shorter end, generally the 30 or 60 day bank bill rates, which will likely be kept low by central banks. Putting it all together, traditional fixed income opportunities across the board will be challenged from a sharp rise in rates.
On the equity side, rising inflation expectations and rates have historically signalled economic growth and optimism, a positive for equities. However, the backdrop has changed as growth stocks and bond proxies have become a much bigger portion of indices and bond yields are rising from historical lows. Growth stocks such as technology and bond proxies such as infrastructure are sensitive to interest rates as their valuation is longer in duration given that future earnings make up a larger proportion of valuation, meaning that a surge in yields could result in a sell-off for equity indices.
We have experienced such a correction before in recent years, namely in late 2018. The gap between the U.S. 10-year yield and S&P 500 earnings yield, which is the inverse of the P/E ratio, has fallen to the same level just prior to the 2018 correction as shown in the chart below.
The intention of this article is not to warn of an impending sell-off but one to understand the risks posed by surging yields and there are of course caveats to both credit and equity performance in the face of higher yields.
On the credit side, default rates may be lower than historical averages as economies experience broad growth, justifying lower spreads. For equities, aside from the fact that the earnings yield gap relationship has a mixed history, rising earnings expectations can maintain or drive the gap higher again, negating the rise in bond yields.
Besides, all this would only matter if yields continue its recent surge. It is not a given despite the indicators as central banks could opt to intervene further. For example, the RBA could extend its yield curve control program to longer maturities, whilst the U.S. Federal Reserve could explicitly implement such a strategy. They cannot simply let the equity market run into a huge sell-off which could potentially spill-over to broader consumer and business sentiment, hurting the economic recovery that they are fighting so hard to ensure.
Markets, ever so fickle, could also see this surge in yields as a step higher before levelling off as the expectation of central bank intervention itself is sufficient to tame the rise. The rally in inflation expectations may also fizzle out as markets may deem that the near term surge in inflation will be transient, and longer term structural factors such as an aging demographic and automation can keep a lid on the effects of large fiscal impulse and strong economic growth in the near-term.
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