U.S. Treasury (UST) yields continued to rise on the back of market expectations of economic recovery in the U.S., upcoming fiscal stimulus and the prospects of higher inflation. 10-year UST yield rose to 1.34%, the highest since the COVID-19 outbreak began in the U.S. The rise in the long end of the yield curve has also forced the curve to steepen. The spread between 2-year and 10-year UST yields reached 123 basis points (bps), the steepest since late 2016 (see right chart of Exhibit 1).

On economic recovery, the USD 900billion stimulus package, which passed in December, has helped to boost retail sales, despite disappointing job numbers. Industrial production and the construction sector are also showing robust performances. Moreover, markets are feeling positive over the prospects of another sizeable fiscal stimulus package from the Biden administration, which could provide additional support to households and small businesses going into the summer. On the pandemic front, the infection numbers are coming down and the progress of vaccination is encouraging. This would imply that the U.S. economy could be propelled in 2Q21 and 3Q21 by both the fiscal stimulus and economic activities returning to normal.

This positive outlook of economic recovery and a higher fiscal deficit are driving bond yields higher. Stronger demand could also drive consumer prices higher. Moreover, investors are also looking at supply side factors at pushing up inflation. Crude oil price (West Texas Intermediate) surged back to USD 60 per barrel due to the economic recovery, as well as supply disruptions in Texas, as a severe winter has taken out production and refining capacity. While global demand for energy is likely to recovery gradually, another variable to watch out for is whether oil-producing countries will start increasing output again to boost their oil revenue after a challenging year. The Organization of the Petroleum Exporting Countries members and Russia are meeting next week. While Saudi Arabia is recommending caution in raising output, Russia and other members seem to be eager to unwind some of their output cuts made in the past 12 months, which could cap the rising momentum in oil prices. 

EXHIBIT 1: Global fixed income: inflation expectations

Source: J.P. Morgan Asset Management; (Left) Bloomberg Finance L.P.; (Right) FactSet, U.S. Federal Reserve.
Guide to the Markets – Asia. Data reflect most recently available as of 19/02/21.

While we do think that the U.S. economic outlook is encouraging and economic and earnings growth could surprise on the upside, consumer goods inflationary pressure will take time to accumulate, especially since unemployment rate is still about 2 percentage points above full employment. As the left chart of Exhibit 1 shows, market’s inflation expectation has picked up, but still modest compared with the pre-pandemic level of long-term inflation expectations. Although there are some temporary supply-side bottlenecks that could raise prices, the Federal Reserve (the Fed) may set that aside and focus on generating more sustained demand-side inflation.

UST yield curve steepening is reflecting the Fed’s commitment to accommodative policy. They are unlikely to raise policy rates until unemployment rate is back to below 4%, which could take another 24 months or more. Yet, the economic recovery could nudge the Fed to slow down asset purchases in early 2022. High bond yields are acceptable when the economic situation improves. However, the Fed is trying hard to avoid an abrupt rise in interest rates, or another taper tantrum.

Investment implications

Headline inflation could pick up in the months ahead as the U.S. economy improves and higher commodity prices kick in, but the Fed or other developed market central banks are unlikely to abruptly change their policy stance. Better growth, low rates and a steeper yield curve are positive for U.S. equities, especially for the cyclical sectors that were badly hit by the pandemic. This calls for a more diversified approach in allocation in U.S. equities, instead of solely focusing on technology and healthcare.

For fixed income, the picture is more complicated. The prospects of higher UST yields continue to force investors to the riskier end of the market. Corporate credit spreads, for both investment grade and high yield, are already at a cyclical low. Room for further compression is limited. This means the coupon is the main buffer to offset the drag on return from a fall in bond prices due to higher risk-free rates. This puts high yield corporate debt in a more advantageous position relative to investment grade, even though its ability to hedge against an equity market correction is relatively weak.

The recent rise in UST yields could also provide some temporary support to the U.S. dollar, as its interest rate differential against other major currencies widen. This does not change our long-term bearish outlook on the U.S. dollar. Its current account deficit and fiscal deficit are still rising. As the global economic recovery becomes more comprehensive, a more positive risk appetite is expected to put pressure on the U.S. dollar to depreciate again. 

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