The recent rise in bond yields is the first potential test of central banks’ determination to keep monetary conditions accommodative as the economic outlook improves. We expect the US Federal Reserve to keep reiterating its recent dovish rhetoric, while possibly increasing the duration of its asset purchases. As for the European Central Bank, an increase in the pace of its asset purchases could come as early as next week.
Daily new cases have stabilised in the US – at around 200 per 1 million, while cases in the UK have dropped to below 150 per 1 million. US hospitalisation rates have fallen in a pronounced fashion with the number of COVID-19 patients currently in hospital now below the April and July 2020 peaks.
In contrast, infection rates in Europe have begun to rise again, most notably in Italy where daily new cases have risen from 200 per 1 million to 275 over the past two weeks. Infection rates in France are also up as is the number of patients in intensive care units. The French authorities may announce new regional restrictions on Thursday.
In Germany, Chancellor Merkel meets with the heads of regional authorities also on Wednesday to discuss possible steps toward a relaxation of the restrictions in place since December.
The biggest headwind to lifting lockdown restrictions is the risk posed by new variants of the virus to the efficacy of vaccines. These variants may keep restrictions on international travel in place, threatening to delay the economic recovery, as countries stay cautious about re-opening.
The rise in bond yields accelerated last week after a weak US government debt auction. Yields of the 10-year US Treasury bond spiked as high as 1.61% before falling back to around 1.45% as of 3 March. Federal Reserve governor Lael Brainard commented on Tuesday on the volatility in US government bond markets saying:
“I am paying close attention to market developments — some of those moves last week and the speed of those moves caught my eye. I would be concerned if I saw disorderly conditions or persistent tightening in financial conditions that could slow progress toward our goal.”
The message from the Fed is dovish, but nuanced as it has stated that the rise in yields reflects market confidence in the economic outlook. At same time, policymakers at the Fed have restated their monetary stance, emphasising patience and stressing that the bar for policy tightening is high. This is now at odds with what is priced in at the short end of the yield curve.
Currently, the interest rate futures market is pricing in just under five rate increases from the Fed totalling 125bp until the end of 2024, with rate rises starting in early 2023. During the recent repricing of US government bonds, the belly of the real and nominal curves underperformed and the very long-end of the yield curves have flattened. Inflation breakeven curves have also flattened.
In essence, the bond market has shifted its attention away from reflation of the US economy to rate rises (and a tapering of quantitative easing). Were the market to insist on this view, it could challenge valuations of risky assets.
Risks to inflation in the US remain to the upside, but if both breakevens and real yields rise, that would be consistent with an improved economic outlook and hence not necessarily negative for risky assets. While higher interest rates mean a higher discount rate on corporate earnings, higher rates also reflect stronger growth and inflation. Historically, that benefit has outweighed any financial drag.
For the European Central Bank, however, the rise in rates is worrying and an increase in bond purchases seems more likely. The challenge is bigger for the ECB as the rise in yields in the eurozone is due more to spill-overs from the US rather than to better economic news domestically. This is reflected in lower inflation expectations, which are not consistent with expectations of rate rises.
Therefore, we think action from the ECB, which is very likely to come in the form of a higher pace of purchases, is a matter of sooner rather than later. The recent yield rise is a clear challenge to the ECB’s resolve to maintain accommodative financing conditions. It is possible that the ECB steps up purchases under the pandemic emergency purchase programme (PEPP) to show its determination. The risk is that this will require an explicit decision from the governing council. If so, this would likely come at its meeting on 11 March.
The cyclical recovery expected for this year will likely be delayed, but not cancelled, by the ongoing challenges of the coronavirus pandemic. Our medium-term scenario favours risk and equities given the fundamental factors and economic policy support.
In light of the recent price action (long-term interest rate tension and the correction in risky assets), we have reduced our short exposure to eurozone sovereign bonds and bought US equities as a step towards larger market risk exposure.
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.