Since the beginning of the year, 10-year US Treasury yields have risen by 25bp to an almost 11-month high as markets anticipate a normalising economy and further, massive fiscal stimulus.
The 10-year Treasury yield hit 1.17% on 8 February, marking its highest point in nearly a year. In the eurozone, the benchmark 10-year Bund yield now stands at around -0.45%. That is about 12bp above where it stood at the end of 2020 and a level not seen since last September. The yield on the 10-year UK Gilt jumped from 0.32% in early February to 0.48% the day after the latest Bank of England monetary policy meeting.
Theory and practice
These higher yields reflect an environment that economic textbooks tell us justify upward pressure on long-term rates: widening budget deficits, accelerating inflation, and accommodative monetary policy.
In the US, the budget resolution approved last week authorises a USD 1.9 trillion coronavirus relief bill. This very large fiscal package could be passed quickly and without much change if the Biden administration chooses to proceed by the way of the reconciliation process. A bipartisan bill, which would need at least 10 Republican Senators supporting it, would likely be much smaller, but still significant in historical terms.
Eurozone bond yields reacted to news of an acceleration in core inflation from 0.2% year-on-year in December to 1.4% in January. Primarily idiosyncratic factors are behind the surge: base effects, the adjustment of the basket of goods and services used to measure price levels, and a VAT rise in Germany. Investors will nonetheless be taking a close look at the detailed inflation numbers due out over the next few days.
Gilt yields rose after more-positive-than-expected Bank of England comments on the economic outlook and indications that a move to negative interest rates was not imminent.
There are also inflation concerns in the US with surveys are pointing to upward price pressures. Market watchers have begun looking for clues in central bankers’ comments on when asset purchases by the Federal Reserve could be tapered.
Fed chair Jerome Powell had indicated that such action would be premature in the current environment. The central bank’s message has been clear: Monetary policy support remains in place.
The ECB has been equally transparent on its stance. In a recent press interview, President Christine Lagarde repeated: “Our commitment to the euro has no limits. We will act for as long as the pandemic is causing a crisis situation in the euro area.”
The crisis is not over
The encouraging progress on vaccination campaigns (at least in some countries) has raised hopes that a return to ‘normal’ life will be possible in a few months’ time. A cyclical recovery would follow for the rest of 2021. We share this view, but would caution that investors not get too far ahead of themselves. The strong 5.5% rebound in global growth expected by the IMF, after a 3.5% contraction in 2020, does not mean that the scars of the crisis will suddenly disappear.
Take the labour market. The US unemployment rate dropped to 6.3% in January and is now at less than half the 14.8% level from last April. Before the pandemic, however, the rate was only 3.5%. Adjusting the current figure for fluctuations related to temporary layoffs and discouraged workers and the unemployment rate is closer to 8%, little changed since last spring.
An old investment adage says, “Don’t fight the Fed.” Indeed, we expect central banks to continue with their massive asset purchases until there is clear progress on growth and inflation.
However premature expectations for much higher inflation and other growth-related concerns may now seem, we believe a short-duration position in eurozone and US benchmark bonds could be opportune at this point. The same goes for a long position on break-even inflation.
We also remain overweight the Italian BTP bond market as the chances of Mario Draghi leading the next government appear to have increased and the risk of early elections has fallen. Investors’ search for yield should provide further support.