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Are higher bond yields spoiling the risk rally?

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By Hussein Sayed, Chief Market Strategist at FXTM

Astonishingly upbeat economic data out of the US failed to send equity benchmarks higher on Wednesday, as consumers across the States decided not to keep stimulus checks in their bank accounts, but rather spend them on electronics, appliances, furniture and online.

Almost every major category in the retail sales report showed a significant increase. The 5.3% growth in January is the largest monthly rise since June, when the US began recovering from strict lockdowns.

Looking at the trend in coronavirus cases and vaccine distribution, we should expect the economic recovery to gather steam over the coming months. Add to this a big, bold fiscal stimulus plan that should speed up the recovery.

According to the FOMC minutes of last month’s monetary policy meeting released overnight, officials are not expected to scale down their asset purchases anytime soon. Achieving the goal of maximum employment will take some time and policymakers don’t seem to be in a rush to shift away from their current crisis mode.

However, inflation is the trickier part in setting policy. Producer prices surged in January, rising 1.3% from December and this marked the largest monthly gain in more than a decade.

So far, the Federal Reserve does not seem that worried about rising prices and they see such moves as temporary and not having a lasting effect.

The combination of robust economic recovery expectations backed by loose monetary policies and supportive fiscal measures should point to further gains in risk assets.

 

Rising bond yields

But one factor seems to be spoiling the party, and that is rising bond yields. Those on the US 10-year Treasury reached a high of 1.33% on Wednesday before paring some of its gains later in the afternoon and is sitting at 1.28% at the time of writing.

The longer term 30-year yield has seen a similar spike over recent weeks, touching 2.11%.

The recent rally seen in yields reflects mainly two things. One is we are finally beating the virus and hence we are headed for strong economic activity. The second part which worries many investors is that inflation may return at a faster pace than previously anticipated.

Going forward, investors need to keep a close eye on how long-term yields behave from here. A steady slow increase may not necessarily disrupt the uptrend in equities, but will likely force rotation from highly priced stocks, typically in the tech sector, to more reasonably priced cyclical ones.

Another sharp spike in bond yields, in which the 10-year approaches 1.75% in a short time frame could pose a big risk to the bullish trend in the overall equity market.

While the greenback is also benefiting from rising bond yields, the magnitude of the dollar’s rise has been limited so far, with the dollar index, DXY, strengthening 0.7% over the past two days. The inverse correlation between risk-on and the dollar will be tested over the coming weeks, especially if yield differentials continue to widen further between the US and the rest of the developed economies.

 

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