Over recent weeks, the upward move in US Treasury yields has resulted in concern that this could result in some short-term turbulence ahead as market momentum continues to run hot in the
first few months of 2021.
The move in the 10-year US Treasury yield from 0.9% at the start of the year to 1.3%, which is about a third of its level, has come alongside an increase in inflation expectations.
In terms of market impact, a sharp move in yields can disrupt markets, although the turbulence could be short-lived as we saw in 2013 during the
taper tantrum.
The latest upswing in yields was exacerbated by a rally in inflation expectations as the vaccine rollout continues to support expectations of a demand-side recovery.
Weather conditions in the US also contributed a sharp spike in the price of crude oil, which contributed further to inflation fears.
In addition to the swiftness of the move in yields, the actual level of rates in absolute terms is the second key factor to consider.
It would have been worrisome if the increase in Treasury yields was accompanied by a sharp increase in real yields, which often puts pressure on markets, especially emerging markets assets.
But that is not the case today. Despite the move up in Treasury yields, real yields (which is nominal yields minus inflation) continue to be in negative territory, which continues to be a supportive factor for equities and emerging markets.
Unlike in Q1 1997 and Q2 2013, where similar sharp increases in Treasury yields preceded hawkish moves from then Fed Chairmen Greenspan (who hiked the Fed Funds rate by 25 basis points in March 1997) and Bernanke (who surprised markets with QE taper announcement in May 2013), we believe that the Fed is now prepared to remain very accommodative through what is likely to be a temporary spike in inflation in mid-2021 (due to base effects) with their primary focus on resuscitating the still very weak labor market.
As stated in the minutes of the last FOMC meeting in January 2021, many members of the Fed committee “stressed the importance of distinguishing between such one-time changes in relative prices and changes in the underlying trend for inflation, noting that changes in relative prices could temporarily raise measured inflation but would be unlikely to have a lasting effect.”
During the 1997 episode of bond turbulence, even after suffering a surprise rate hike, the equity market swiftly recovered in the second half of the year after a c.10% correction.
During the 2013 taper tantrum when bond markets were roiled, the equity markets were range-bound for a few months before continuing its upward trajectory as investors mostly looked through to the broader story of the post-GFC recovery and a positive macro outlook.
With a vaccine driven recovery still on-going, we believe that the broad outlook for risk assets remains positive. Given the degree of slack in labor markets, we believe that impending rise in inflation in mid-2021 is likely to be transitory even though it could contribute to fears amongst investors of an inflation spike and result in sentiment-driven but near-term volatility.
Importantly, policy makers are likely to remain very accommodative. Not only has both Fed Chairman Powell and Treasury Secretary Yellen emphasized repeatedly that they expect policies to remain very loose this year in view of the high unemployment rate in the US, the US government is now working through a sizeable new stimulus package which we expect to be meaningfully above USD1 trillion in size and should pass sometime in March. This would form yet another key supportive factor for markets.
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