The sell-off in US (and global) government bond yields, which began after Fitch Ratings downgraded the US default rating as a long-term foreign-currency issuer from AAA to AA+ on 1 August, pushed the 10-year Treasury yield to 4.36% on 19 September, its highest since 2007.
Rising real yields initially drove the increase as markets reflected the concerns raised by Fitch about the poor debt outlook for the US.
Over the last few weeks, however, real yields have been relatively stable, while it has been inflation expectations which have risen (see Exhibit 1). This move reflects the increase in oil prices, with Brent crude oil now topping USD 90 a barrel.
We believe this rise in US Treasury yields has mostly run its course now and anticipate lower yields from here on. While energy suppliers such as OPEC would prefer yet higher prices, at a certain point higher oil prices will begin to crimp growth and hence demand.
In addition, both the US Federal Reserve and the European Central bank are more likely than not at the end of their hiking cycles. The effect of the hikes over the last year has yet to be fully felt by the US and eurozone economies, suggesting growth will continue to slow. This should allow real yields to ease. Eventually, the two central banks can be expected to begin cutting rates, giving a further impulse to declining real yields.
Equities have struggled with higher yields
Equities, and in particular US growth stocks, have not reacted well to the increase in (real) yields.
The tech-heavy NASDAQ 100 was down by 7% at one point in August versus a 3% decline for the wider US market, but things have since improved and returns for both are now around -3% from this year’s peak.
If our view that yields decline from here on is correct, that would in turn be supportive of equity markets. Any downside risk would come rather from earnings expectations, which may weaken as growth continues to slow.
Inflation data – Dilemma for the Fed
The increase in oil prices is not the only factor that has pushed inflation expectations up. The latest US Consumer Price Index (CPI) for August beat expectations in a bad way, that is, inflation came in higher than expected.
Headline inflation (including food and energy) was 3.7% year-on-year compared to a forecast 3.6% and a reading of 3.2% in July. Core inflation (excluding food and energy) also came in higher, at 0.3% month-on-month versus a forecast 0.2%.
As has been the case for many months, the increase in core inflation was driven primarily by higher shelter (housing) costs. While this part of the CPI basket is still rising at a fast clip, the Fed appears to be less concerned about it as the central bank believes that with higher mortgage rates, housing prices will eventually fall (albeit slowly).
Core inflation excluding shelter has been far lower, rising by less than 2% on an annualised basis for the last few months. In August, however, the core index rose at a 3.4% annualised pace (see Exhibit 2).
There is some comfort to be found in the fact that the higher inflation rate in August was mostly due to transportation services, in particular car insurance and airfares, which should not continue to rise so quickly in the months ahead.
It nonetheless highlights the dilemma for the Fed: inflation is still well above its 2% target, and even if the impact of previous hikes has not been fully felt yet, it is likely too soon for the Fed to step back and loosen monetary policy.