The only subject of interest now is around the reflation argument. Nothing else has changed – vaccine rollout and fourth quarter company results have, overall, been good. The US economy is recovering more quickly than Europe and we have seen more stimulus – factors that we have been watching for a while now. The market is certainly taking a breather, and it remains to be seen if this current bout of curve widening is enough to derail things for a while. This will be transitory as the technical support remains very much focused upon normalisation.
Another week, another move
Another week, another move higher in US Treasury (and Bund) yields. Clearly this debate over inflationary pressures is not going away in the short term. The US Treasury 30 year is now above 2.15%* and the inexorable move higher seems to be entrenched for now….or is it? We have breached several resistance levels already and it certainly seems that, so far, the financial markets are (mostly) taking things in their stride.
The real concern will be whether yields move high enough to stall any further equity market rally and indeed the nascent economic recovery from here. In Europe there is no real sign of inflationary pressures building, but it will be interesting to see how far Bund yields get dragged along by Treasuries. The move in Bunds is more of a valuation versus Treasuries issue rather than any real concern over inflation, tapering or inflation in Europe.
The 10 year Bund is rich by about 15bps*, so the path of least resistance could be a move closer towards 0%. In addition, watching dividend and bond yields will be all important to the bond/equity discussion. Gradually rising yield curves are not a problem, it is sudden, sharp moves higher that will begin to impact investor sentiment. If we look what is being priced in by the market, there is one incremental interest rate hike for mid-2023, which has been brought forward from early 2024**. Consequently, at the moment, futures are taking a longer-term view on interest rates.
Reaction to good news
But, let’s not forget this is in reaction to good news – I still expect an acceleration of the vaccine rollout in Europe and a continuation of the efficient distribution we have so far seen in the US and UK. Current vaccines look like they reduce transmission significantly, and have a positive effect on current variants. We should begin to see an enhanced effect of case reduction as the weather become milder as well. The economic recovery and subsequent boost is still the central case for the moment. All of this is still supportive of risk assets.
As investors move into commodities in reaction to inflationary concerns, so the perception of inflation goes up. Currently, a significant spike in inflation seems to be transitory especially as we will still see high unemployment and a recovering, but damaged, economic environment. Supply chain disruptions continue to be a concern although this should be transitory.
In summary, we believe that there will be no move higher in interest rates this year (as distinct from government bond yields) and equally there will be no withdrawal of underlying fiscal or monetary support. We would need to see economies on a permanent and sustained road to recovery, an end to the pandemic and a recovery in employment before we see a withdrawal of fiscal and monetary support. Whilst we could see an acceleration of re-employment, especially in the hospitality sector, it is still going to take time.
Where do we go from here?
It feels like we should have a pullback, but re-opening optimism continues to be the focus so far. It will be interesting to see how this plays out in the next few weeks. Our fixed income strategies are positioned for the recovery trade.
*Mirabaud Asset Management, 22/2/2020
**Bloomberg, February 2020
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