Are higher US yields becoming a threat to markets?

The prospect of a huge fiscal stimulus package, lower taxes and positive news about vaccinations has driven US Treasury yields 65 basis points higher this year to about 1.60% (March 8th 2021). It began with investors expecting inflation to return sooner than had been expected. This was the main reason for yields rising through mid-February. Since then, however, investors have also started to anticipate that the US Federal Reserve would hike rates, which pushed US Treasury yields even higher. European yields followed, but by only about half the increase seen in US yields.

In contrast, equity markets have been supported by the increase in inflation expectations, which signal the world economy is recovering. However, the increase in interest rates since mid-February has produced a different impact on equity markets. Market volatility has increased significantly and profit-taking has occurred, in particular, on growth stocks. Inflation fears have also led to the significant outperformance of cyclical and value stocks. In Europe, the two best-performing sectors year to date are materials and financials.

In the near term, we believe that yields could continue to move a little higher, feeding further volatility in stock markets. The US central bank does not mind higher yields caused by inflation expectations. It will, however, have a problem with yields rising further caused by investors who are expecting the Federal Reserve to react more aggressively than planned. Such an overreaction could slow the recovery by tightening financial conditions for companies and consumers. Down the line, this could also affect equity markets, feeding volatility and putting growth stocks, in particular, under pressure.

For the second half of this year, we expect US long-term yields to come down and to fall more in line with short-term yields, resulting in a flattening US yield curve. This is because we believe that inflation data is being distorted by statistical noise from the impact of the pandemic. We also believe that the idea that inflation will quickly return is misguided. Instead, we think that it will still take two to three years before we are back at pre-pandemic employment levels – and even these levels did not previously produce inflation.

Once investors realise that a return to inflation is not around the corner, yields should fall back and the Fed will continue to be supportive and accommodative. This will also likely lead to less market volatility; and growth stocks could be in a position to stabilize. In this situation, stock investors would be rewarded, as economic growth and earnings recovery continue to support markets.

Bond markets are another story. The flat and steeply negative European yield curve leaves investors with a high risk of negative interest returns on bonds. The highest quality bonds, such as core government bonds, may actually be the biggest disappointment to portfolio performance in 2021. While holding these bonds in the past has provided a buffer against hard times for portfolios, this protection is no longer available given negative yields. Core European government bonds are therefore not in favour. We also recommended selling long US Treasury positions in early February. In time, US Treasuries could again become useful for portfolio protection, when reflation trades overshoot and reflation pressure eases.

Our asset allocation continues to favour stocks (modest overweight) over bonds (neutral). Our sector allocation is aligned with the current market dynamic. We are well positioned with a balanced portfolio tilted toward cyclicality and value. In particular, we prefer (overweight) the materials, industrials, consumer discretionary and financials sectors, with a neutral stance toward technology stocks. For the time being, we do not consider the correction in technology stocks to be a buying opportunity.