During the past week, it has been interesting to observe a pattern in which Treasury yields and US equities seem to be yo-yoing in opposite directions; lower stocks beget lower yields, which in turn lead to higher stocks, higher yields and then lower stocks. 

 

As described over recent weeks, risk assets have become more sensitive to yield movements since real yields have also started to move. Some (retail) equity investors may not fully appreciate that the stocks they own infer rights over a future stream of cashflows and that, in the case of stocks with high P/E multiples, this implies assets which have a very long average duration.

 

However, looked at in this way, an increase in the rate at which future cashflows will be discounted can clearly have a very substantial impact on the valuation of such assets, even if the robust economic growth backdrop points to a vigorous improvement in sequential earnings. 

 

This inter-play between risk assets and bond yields may continue to form a self-corrective pattern for the time being. In a sense, it makes sense for markets to be held in some suspended animation after a period where we have witnessed some pretty substantial directional moves. However, this won’t last forever and ultimately underlying fundamentals will come to the fore. 

 

 

In the month ahead, we believe that the US fiscal package will pass through the Senate and we should see Covid further in retreat, as vaccination programmes continue to make progress. US economic data for February (including this week’s payroll release) may be impacted by the extreme cold weather in the past month, but this can serve to lead to an even more resilient rebound in the month to follow. Meanwhile, growing evidence points to building price pressures, with the prices paid component of the ISM services survey jumping to a 12-year high this week. 

 

We believe that inflation on the Fed’s favoured core PCE measure could rise above 2.5% in the April release (due out in May), putting inflation above target. Part of this move may be transient, but as the economy continues to strengthen, we are becoming more confident that inflation will not dip very far thereafter. 

 

Consequently, we continue to believe that the Fed narrative could change around the middle of the year and that, ultimately, we will see a renewed rise in Treasury yields. Indeed, Powell’s speech yesterday did little to talk down the economy or yields for the time being. 

 

Although the Fed will be sensitive to a rapid move and a sharp tightening in financial conditions, it seems that there is unlikely to be much intervention in markets at this stage and so the path of least resistance could continue to be for yields to move up. 

 

It remains to be seen whether solid earnings growth mean that stocks can ‘out-run’ this move in yields, but generally speaking, we think that overall beta returns in many markets may be subdued in 2021, in part paying back for the super-charged gains of 2020.

 

 

During the past week, ECB officials continued to make comments aimed at stemming any rise in yields. However, there was no evidence of an increase in ECB bond purchases under the PEPP programme last week to suggest that actions were backing-up their words. Nevertheless, we feel that the tolerance of the ECB to a continued sell-off in bonds is now relatively low and we would expect the central bank to intervene, should yields move above recent highs. 

 

Elsewhere in the Eurozone, there continues to be no shortage of recriminations and introspection at the slow pace of vaccine rollouts compared to the situation in the US and the UK. Notwithstanding this, we can see supply issues being addressed in the weeks to come. Consequently, we think that much of the EU may only be lagging behind by 6-8 weeks. 

 

Meanwhile, lockdown restrictions in much of the EU are far more relaxed than the situation in the UK, where schools will open next week for the first time in 2021. By contrast, in Spain, public dining continues to take place and thus it will take time for UK restrictions to be unwound to match Continental levels. 

 

In this context, although the UK vaccine programme has been praised, it appears that GDP won’t return to end-2019 levels before late next year, even with the Chancellor announcing further significant near-term stimulus at the Budget this week. Moreover, we believe that plans to raise taxes and rein in spending in the years thereafter imply far more austerity than is needed.

 

Consequently, we are not especially optimistic around medium-term UK economic prospects. From this point of view, sterling has been an outperformer in 2021 thus far, thanks to vaccine success, but we question how long this will be sustained, with Brexit effects likely to be felt for many months to come.

 

 

The region continues to be challenged by the external backdrop. In Brazil, yields continued to rise sharply on fiscal concerns, before rallying towards the end of the week.

 

More generally speaking, countries which are serial capital importers have seen themselves under pressure, though elsewhere, firm commodity prices have been supportive to other countries. Oil prices registered healthy gains as OPEC quotas pushed crude back to levels last seen in 2018. 

 

Meanwhile, a softer forward-looking outlook in China detracted somewhat from sentiment. Emerging market credit and FX was on the back foot during the past week, with local and hard currency indices now down around 3-4% since the start of the year. However, it should be noted that this largely mirrors moves in Treasuries, with similar returns also seen in asset classes such as US investment grade corporate credit. 

 

Notwithstanding this, corporate credit spreads have remained relatively stable over the past month. Higher yields have led to increased demand for paper and order books for new issues continue to point to a healthy underlying market technical.

 

 

We feel that US rates hold the key to broader market developments. Having reduced risk, we are well positioned to add to short duration positions in US rates, whilst adding long risk asset exposures if a flight-to-quality emerges, pushing yields and equities lower. Conversely, if yields rise then we are more inclined to continue to sell risk assets and move US duration back to flat, fearing that the following move will see markets retrace. An overshoot is possible in either direction and therefore we are happy to be in a position to respond either way, should such an outcome occur.

 

During 2021, our medium-term conviction is for expansive policy to drive robust growth, firmer inflation and higher yields. Although we are not anchored on a particular forecast, we see scope for 10-year Treasuries to rise above 2% by the end of the year. We think that such a move can create a challenging environment for risk assets more generally, as the long-dated discount rate moves higher. 

 

Having said this, it may seem too premature to believe that such an extended move in yields should occur just yet, and therefore a bigger sell-off in rates could be a risk for later in the year. Arguably, this may need to see validation in terms of a change in Fed rhetoric, which remains some way off. 

 

From this point of view, what we may be witnessing now could be viewed as some of the early tremors in the build up to an earthquake, which strikes at a later date. However, the problem for investors is that once the ground starts shaking, how do you carry on in the knowledge that this isn’t ‘the big one’? It seems time to proceed with caution. 

 

Like this week’s Space X rocket landing, all may look broadly OK for now, but we can’t rule out the risk everything isn’t about to tip over and blow up.