New month, same concerns?

Spring is in the air for the Northern hemisphere, and the key question as we move into March is whether or not the blistering sell off in global bond yields will continue. This time last week, US 10-year Treasury yields were trading below 1.35%, as we move into a new week, 10-year yields are trading at 1.41%, however, on Thursday the 10-year yield had briefly touched 1.6% in the biggest rout for the US Treasury market since March 2020. The driver of the sell-off was concerns about the bid-to-cover ratio of a US government debt auction, where 40% of the amount for sale was bought by the underwriting banks, which is the highest level for 7 years. The panic in the market dissipated at the end of last week, but could the damage be permanent? Rising interest rates have cooled sizzling rallies in US and emerging market stock indices, the question now is, will it last? 

Our view on where bonds could go next 

If you read our research regularly, we have stated that we would not expect equity rallies to break down permanently unless the 10-year Treasury yield breached the key level of 1.6%. While we were correct in assuming that 1.6% is an important level for the market, and 10-year Treasury yields quickly backed away from this level on Thursday, the question now is, are we in a new paradigm for yields and expectations for global central bank policy? We believe that we are. While the doves still have control of the US Federal Reserve, and we don’t see interest rate increases any time soon, we also don’t see further stimulus coming soon. Thus, while a change in US central bank policy could be some way off, it’s a question of when not if policy will be tightened. The sell-off in global bond yields, and specifically in US Treasury yields is down to three factors: firstly, Joe Biden’s stimulus package was, finally, passed by the House at the end of last week. This $1.9bn package will unleash another wave of federal cheques that will be sent directly to taxpayers in the mail for them to spend on what they wish, the rest of the package is mostly spending based, with minimal tax cuts, which is fuelling concerns about inflation. This combined with vaccinations and the opening up of the US economy is another reason why some believe that the inflation genie could be about to be let lose from the bottle. 

Is the Fed concerned about rising bond yields? 

Secondly, the Fed haven’t directly mentioned anything about the fast pace of rising bond yields. This leads some to wonder whether the Fed is happy for the market to do some tightening for them. While the Fed chairman sounded relatively dovish in a speech last week, he seems to have shifted from his uber dovish stance at the beginning of the year. As we have mentioned, it’s not only US bond yields that have been rising, so too have UK bond yields, the 10-year Gilt yield rose 50 basis points in February. On Friday, the Bank of England’s chief economist spoke about inflation threats, which reinforces the recent sell off in global bonds. In contrast, the only major central bank that has sounded concerned about rising bond yields is the ECB; its chief economist said last week that they are watching bond yields closely and will intervene if there are disorderly moves in Eurozone bond markets. This suggests to us one key market trend, the continued decline in EUR/GBP. This pair has already enjoyed a decent decline as sterling has surged this year, and it was above 0.90 in December, it is currently trading 400 points lower at 0.8669. We believe that the lows from a year ago might be calling, with 0.85 the next major level of support. 

Have central banks worn out their war chests? 

Lastly, the “bond vigilantes” who targeted government bond markets last week are doing so because they believe that major central banks have maxxed their credit cards during the coronavirus pandemic; the economic recovery that is likely to materialise in the coming months and years will lead to central banks pulling back from the largesse of 2020 and putting monetary stimulus on a more sustainable footing. This means that the Fed won’t continue to engage in quantitative easing at their current pace of $120bn a month indefinitely. We believe that central banks won’t rush to slash their QE purchases, but equally they won’t be extended anytime soon either. We balance our view that central banks such as the Fed and the BOE (the ECB is a different story) will want to step back from buying government debt, with the reality that these central banks need to finance the massive fiscal spending programmes that the US and UK governments’ have embarked on during this covid pandemic. Thus, the road to monetary policy normality post the covid pandemic is long and it won’t be smooth. We should expect further bouts of market panic and volatility in the coming months, especially as key benchmark bond yields reach important levels of resistance; imagine what the bond market will do if the 10-year Treasury yield hits 2%? 

Three things to watch out for this week

Now that we have explained our position on bond yields and what these mean for financial markets (basically a weaker euro), there are three events that we are watching closely this week. Firstly, what next for the FTSE 100? The FTSE sold off at the end of last week and was the worst performer in Europe. Stocks in the FTSE 100 slid more than 2% on Friday, so is it time for a recovery? The prospect of rising bond yields is bad news for the FTSE 100 because of the large property and energy companies in the index, thus, the new paradigm for bond markets could be a drag on the FTSE in the longer term. Also, until spacs are given the green light for the UK, the UK may struggle to perform in line with the US and some European indices. Any progress on UK spacs could trigger a sizeable boost for the FTSE 100, so watch out for any news on this issue. News that the Astra Zeneca/ Oxford vaccine will be approved for the over 65s in Germany could be cancelled out by news on Sunday that the deadlier Brazilian variant has been found in the UK, with one paper reporting that a carrier with this variant of the virus has “disappeared” within the UK. Thus, UK stocks may not recover first thing on Monday as the market digests this news that could threaten the reopening of the UK economy later in March and April. 

Eurozone inflation: nothing to worry about for now 

Secondly, we will be looking at Eurozone inflation, which is released on Tuesday. The preliminary data for February is expected to show that the core rate of inflation, which is used by the ECB to set policy, fell to 1.1% from 1.4% in January. Headline inflation is expected to rise slightly to 1% from 0.9%. While inflation has risen since its nadir last year, it remains some way off the ECB’s target rate of 2%, and the fall back in inflation that is expected in February, largely due to lockdowns across the bloc, suggests that price pressures are not as strong in Europe as they are elsewhere. The slow progress of the vaccination roll out in Europe, combined with fears of more lockdowns in France and Germany could keep the lid on inflation, which is also bad news for the euro in the longer term. 

Payrolls and spare capacity in the US economy 

Lastly, while we will look at the UK’s Budget in more detail later this week, the US Non-Farm payroll report is also key to watch on Friday. The February data is vital to give us an indication of how much spare capacity there is in the US economy. The market expects an increase of 148k jobs, which would be the strongest rate of jobs growth since November, however, it is still a fairly modest rise considering a healthy US economy usually creates 200k+ jobs per month. Thus, if jobs growth comes in weaker than expected, that suggests that there is more spare capacity in the US economy than some may have thought, which means that Biden’s stimulus plan may not be as inflationary as some have assumed. So, a weaker payrolls number on Friday could calm battered bond markets and be good news for stocks. 

Overall, President Biden’s first month of office was not good for the stock market, as investors bought the rumour of his stimulus plan in January and then sold the fact in February.