U.S. Treasury (UST) yields have been rising since the start of the year. The 10-year UST yield broke above 1% on Jan 6 for the first time since the COVID-19 pandemic gathered momentum in the U.S. in March 2020. This has triggered several concerns among investors. Is it a signal of inflation picking up? Could this derail economic recovery? Could this end the U.S. dollar (USD) bear run and put pressure on emerging markets again?
The latest rise in UST yields was largely brought by the result of the Georgia Senate run-off elections. These two seats, along with Vice-President-elect Harris’ tie-breaker vote, gave the Democrat Party a razor-thin majority in the Senate, implying a clean sweep of both chambers in Congress. More fiscal packages are hence on the cards to support the economy, following the USD 900billion (bn) package passed at the end of 2020. This should boost investor confidence on the economic outlook in 2Q and 3Q 2021, despite the latest challenges of high infection, hospitalization and fatality. By 2H 2021, the vaccination program hopefully would help to control the pandemic and allow for economic activities to gradually resume.
In addition to reduced downside risk to growth, the UST market is also reflecting the prospects of higher fiscal debt because of more stimulus programs in the future. While this could be true on the supply side for government bonds, how the Federal Reserve (Fed) reacts, and indirectly by other central banks with their quantitative easing programs, would determine how much bond yields could rise.
After the December Federal Open Market Committee meeting, the Fed reiterated its commitment to buying USD 80bn of UST and USD 40bn of asset-backed securities each month until there is ‘substantial further progress’ toward its inflation and employment goals. In the meeting minutes released last week, Fed officials have also stressed the importance of clear communication to the markets on adjusting the pace of asset purchases. This implies that the Fed will be paying attention to the level of UST yields and prevent excessive rise threatening economic recovery.
On inflation, we do recognize that headline inflation is likely to rise in months ahead due to the low base from last year. This is reflected in higher inflation breakeven points from Treasury Inflation-Protected Securities (TIPS). However, this supply side-driven inflation is unlikely to influence the Fed’s dovish position.
In sum, we think there is room for 10-year UST yield to rise (20-40 basis points (bps) from current level) in months ahead, especially if the rollout of vaccinations is smooth with high take-up rate by the general public. However, the Fed is expected to stand ready to prevent the long end of the yield curve derailing recovery. Meanwhile, short-term interest rates should be anchored close to zero, implying a steeper yield curve (right chart below).
EXHIBIT 1: GLOBAL FIXED INCOME: INFLATION EXPECTATIONS
There are pros and cons to higher government bond yields for investors. On the positive side, this reflects that investors are expecting economic growth to improve. This should be positive for risk assets in the medium term, especially for global equities. Rising yields historically have also supported value stocks and hence provides some important impetus for the current value stock rally to continue. Banks benefit from a steeper yield curve as this implies wider interest margins, as well as higher level of activity with a recovering economy.
However, government bond yields rising too fast can be problematic for financial markets. The taper tantrum in 2013 saw the 10-year yield rise 140bps between May and September that year. This created sell off pressure in the fixed income market. As mentioned above, we think the Fed has learnt its lesson on avoiding surprises, which should reduce the risk of triggering market panic. Nonetheless, higher government bond yields could impact the total return of fixed income assets. For corporate credits, the negative price impact from higher risk-free rates (10-year UST yields) are typically offset by tighter credit spreads. However, since credit spreads for U.S. and European corporate credits are already close to their 2020 lows, room for compression is limited. For equities, those markets or sectors with relatively high valuations are also more vulnerable since the discount rate has risen.
In the near term, the rise in UST rates could also underpin a rebound in the USD. U.S. current account and fiscal deficits and improvement in risk appetite have pushed the USD weaker. The latest bout of yield increase would improve the appeal of U.S. government bonds relative to other developed market government bonds and support the USD. Moreover, the market positioning against the USD seems stretched and therefore prone to a rebound. Nonetheless, we still believe the risk to the USD remains on the downside in the medium term.
Overall, the rise in UST yield is consistent with our preference for risk assets, especially equities. This calls for a more diversified portfolio in global equities, instead of just focusing on the winners of 2020. Europe, Japan and the Association of Southeast Asian Nations (ASEAN) members should benefit from more comprehensive global recovery as well as cyclical sectors, such as financials, materials and consumer discretionary. High yield corporate credits and emerging market fixed income have higher yields and hence more resilient to the rise in risk-free rates and decline in bond prices.