BlueBay AM: Anticipating a tantrum

February 26, 2021

By Mark Dowding, CIO at BlueBay Asset Manager

Moves in government bond yields continued to grab investor attention over the week, with 30-year Treasuries rising to 2.30%. As the virus recedes and the economic outlook brightens, US yields have risen by more than 50bps since the start of 2021 to a 12-month high. This move has been mirrored in other global markets.

Against this backdrop, Powell’s Senate Commission Testimony provided a platform to reassure markets that the FOMC was still far from the point at which it plans to signal a removal of policy accommodation. Earlier in the week, Christine Lagarde also made remarks that the ECB was monitoring movements in bond yields.

In this context, we sense that central bankers are becoming concerned at the speed and magnitude of the recent rise in yields and may be inclined to step up their verbal intervention in the days ahead, if recent trends are to persist.

Reflation expectations

Nevertheless, the reflationary theme remains largely intact and action on the fiscal policy side may yet count more than central bankers’ words. It is understandable that the Fed is eager to prevent a premature tightening in monetary conditions at a time when we are still in the middle of a pandemic, with unemployment at elevated levels.

Yet, investors are forward-looking and, from this point of view, it is similarly understandable that the number extrapolating higher bond yields may continue to outweigh those looking for the market to rally. 

Part of the problem for the Fed is that if it promotes an overly dovish message, then markets may choose to disbelieve it and the Fed’s credibility could be questioned if inflation is simultaneously rising and unemployment is falling in the wake of strong economic growth.

Underlying the move in Treasury yields, it is arguably developments in real rates that could have a greater impact on other asset classes. 

Nominal bond yields have been trending higher since last August, but up until recently, real yields have been little changed as breakeven rates of inflation have widened. However, with 10-year Treasuries moving above 1.25%, inflation break-evens have struggled to grow further, meaning that real yields have started to move upwards and this has begun to impact broader risk appetite.

Equity indices are off their highs and in emerging markets, benchmarks have continued their underperformance from the start of the year, as markets speculate on an eventual turn in the US policy cycle. 

Corporate credit has performed better thus far on a spread basis. Here, higher absolute yields encourage LDI-driven investors and other yield-sensitive buyers to put cash to work in the market. Yet, there seems to be an underlying concern that if the move upwards in Treasury yields does not abate soon, so the risks are growing of a repeat of the taper tantrum seen in 2013, when markets dropped after the Fed announced it would be reducing its bond purchases. 

Looking forward

It seems that risks may be rising, but for now, sentiment is holding up OK. Evidence to support this thesis was seen this week in the surging valuation of the Churchill SPAC (Special Purpose Acquisition Company), whose acquisition of Lucid Motors placed a USD24 billion valuation on a company yet to sell a single car. Certainly, that seems pretty good going when one considers this market capitalisation is double that enjoyed by an established auto company like Renault in France. 

As an aside, watching the price performance of SPACs has been of growing interest over the past several months. It is clear that there is plenty of money looking to participate in new transactions, as evidenced in the oversubscription in this deal’s PIPE (Private Investment into Public Equity). Private markets continue to be hot for now, but it will be interesting to see if sentiment changes in response to developments across other asset classes.

Generally speaking, we have a sense that the direction of government bond yields will hold the key to broader market direction. Our central expectation would be for the sell-off in rates to pause for a time. If this can occur, then there remain opportunities to exploit positions in corporate and sovereign credit and we would look for compression to occur. 

However, if market technicals push yields higher and central bank comments fail to calm price action, then we could be in for another bumpy March. We had hoped we could sit long of risk assets in the first half of 2021, before moving more defensive later in the year. This may still be the case and there is sense in wondering whether the ‘big’ move in rates will occur later in 2021.

From this point of view, we may have travelled far enough already in this particular mini-cycle, with the 5-year forward rate on the 10-year note already close to 2.5%. However, timing this is a somewhat tricky call to make and if US yields trade rapidly towards 1.75% on the 10-year, then we would not be surprised to see the S&P drop 5% or more, triggering a retrenchment in corporate bonds and emerging markets. 

We are hopeful that a tantrum can be avoided in the month ahead, but we think it is wise to be prepared, just in case.