Stronger, faster, louder
Equities are outperforming bonds, yields are rising, and the US curve is super-steepening. The Fed is doing a reasonable job of anchoring short-term interest rate expectations, but the longer end of the curve reflects the reflationary boom. It is making US fixed income attractive again. Yet the move up in yields is probably not over and few will be surprised now if and when the market crosses the 2% yield level. That is no disaster. The US economy is in fully party mode.
Growth up, rates unchanged
The US Federal Reserve (the Fed) endorsed the reflation trade this week. It revised up its median 2021 GDP growth forecast to 6.5% (from 4.2%) and its median core PCE inflation forecast to 2.2% (from 1.8%). At the same time it kept policy settings unchanged and “officially” ruled out any increase in the Fed Funds interest rates until at least 2024, at least in terms of the median forecasts set out in the Summary of Economic Projections published alongside the summary of the Open Market Committee meeting. Contained in the nuances of the report there is a little bit more divergence of views amongst committee members about where rates will be in over the next couple of years, but the median expectation remains for no change. Chairman Powell was pretty clear on a number of occasions about not raising rates until the Fed was confident that the economy had met its targets – full employment and inflation above 2%.
Steeper and steeper
The markets continued with the reflation theme. The US Treasury yield curve steepened, value stocks outperformed growth, and commodity prices generally moved higher. In discussions of the US outlook with a number of participants in the markets this last week, it is clear that the consensus of strong growth and rising inflation is a solid one. It’s still not clear that the market fully buys into Jay Powell’s “party on” mantra, but it is not clear either that there is support to price in interest rate hikes coming much earlier than that suggested by the Fed. So, 2-year yields remain well within the range that has been in place since last Spring. At the same time, the 5-year part of the curve is reflecting that by 2025-6 we will have seen the first and possible several rate increases – yields are up 55 basis points (bps) since the beginning of the year.
It’s quite unusual to see yield curves steepen when the official policy rate is close to zero and is expected to remain there for a while. Most of the time curve steepening is driven by big falls in short rates as monetary policy is eased in a recession. This time around it is being driven by a normalisation of inflationary expectations and real rates after a long period of repression by the combination of policy, low growth and deflation. The gap between 2-year and 10-year yields is now close to 160bps which is above the long-term average. The move in that spread from zero in the summer of 2019 is one of the larger cyclical moves in the yield curve, starting to compare with the moves seen in 2001-03 and 2006-2010 (both periods were associated with around 500bps of monetary easing). The continued steepening will test the Fed’s resolve and when eventually the Fed does tighten, there will be an almighty flattening of the curve and the trade will be maximum long-duration in bond portfolios. However, that’s a way off yet.
How high can they go?
In the meantime, it is worth thinking of how high yields could go. One metric would be to think about where long-term inflation expectations will settle and where real yields will settle. Our view is that inflation break-evens at around 2.4% are consistent with the Fed’s average inflation target. Real yields have averaged 0% since the global financial crisis. Putting the two together would target 2.4% 10-year Treasury yields. A second approach would be to look at the cyclical position. I de-trended the path of Treasury yields by looking at current yields relative to their 3-year average and plotted that against the ISM index of manufacturing activity. There is a good fit in terms of how they behave through the cycle and it suggests that the level of yields is still too low relative to where the economy is. This is not an econometric model, but it could be used as an argument to point to yields being closer to 3%. At any rate, it should not be surprising if yields move higher still – after all that is what forward markets are pricing.
The moves make US dollar fixed income more interesting. Long-dated US investment grade credit now yields above 3.0%. For the BBB-rated index the yield is 3.25%. Long-dated European credit barely yields 1%. With US short-rates stable the foreign exchange hedging costs remain relatively low so USD bonds hedged into Euros give a higher yield than equivalent investment opportunities in the Euro denominated market. The yield to worst on the US high yield index is also 50bps higher today relative to its recent low. Make no doubts about it, we remain in a low yield world but forward looking fixed income returns have become meaningfully more attractive than they were at the beginning of the year. Year-to-date, the bond asset class in general has not been a good performer. But looking ahead the return outlook is starting to improve.
US, Asia, emerging markets…
Having said that, we are mostly talking about US$ denominated assets. Benchmark 10-year government bonds in Europe have seen less of an increase in yields and in many markets (Germany and France, for example) the yield remains negative. In sterling, gilt yields are less than 90bps. Peripheral bond yields are nothing compared to what they were in past years. No, it is only the US and other dollar markets that looks interesting today. Asian US$ denominated bonds are higher yielding, as are dollar denominated emerging market bonds in general. The yield on a widely followed EM debt index is 5.2% at the moment. If the US economy is going to boom then this should be a positive for emerging market economies and support their recoveries from a COVID-19 ravaged past year. Obviously, however, we need to take care to consider the impact that higher US rates could have on EM economies through the potential channel of a stronger dollar and higher inflation.
Apples and pears
I’m also a little sceptical about comparing bond yields with equity yields. I’ve noticed a few comments related to the fact that the 10-year Treasury yield is now above the dividend yield on the S&P500. This is a far too simplistic measure and appears to have no signalling properties for future relative performance. An income focussed equity investor would not have a portfolio that looked like the S&P, it would be more exposed to higher dividend paying stocks and would have a commensurately higher yield. Just looking at the S&P value index, it has a trailing yield of 2.16% compared to the S&P’s 1.47%. Other baskets of equities can be constructed with even higher yields. An equity index is a heterogenous collection of securities with many factors impacting on valuations and cash-flow returns. Dividend cash-flows do grow over time – the essence of investing in stocks. Comparing “a” dividend-yield on a basket of equities with a homogenous bond with a fixed coupon (that does not grow) is not a very sophisticated approach to asset allocation.
The value versus growth relationship in the equity market is also interesting. Value is outperforming as yields rise and within that there are businesses that are more cyclical. Financials are also benefitting from rising yields as net interest income is perceived to be boosted. These are cyclical trends. Earnings growth will be strong in the short-run therefore discounted with still low short-term interest rates. Growth stocks with earnings in the future are suffering from earnings being discounted by higher long-term yields. This will play out some more I suspect. Yet when I look at the maker of the world’s most popular mobile handset, it’s long-term earnings growth is estimated at 9.5%. I would want that kind of asset in my portfolio. Don’t give up on growth. Indeed, treat the adjustment in current prices as a potential boost to longer-term expected returns.
The US is leading the reflation. It is doing a great job vaccinating people (100 million people so far) and much of the economy is re-opening. Households are now starting to receive $1,400 checks per person. That will boost spending. Excess savings should also come down, boosting spending. The Fed is not exactly tipping another bottle of Vodka into the punch bowl, but it is letting the Treasury do that and is in no rush to take the booze away. After the last year of no partying….the message is turn up the music. (Side note: my son, having had two jabs, is off to Miami for Spring break. If the idea of lots of 20-22 year-olds dancing around the swimming pool is not a sign of a return to normal I don’t know what is!)