“US equity valuations are sustainable as long as the US 10-year yield does not go above 3%,” the Schroders multi-asset team warned four short weeks ago.
Then, the yield was at 2.65%. It’s continued to advance since. Last week the number peaked above 2.9%, a well-publicised four-year high, having ended 2017 at 2.4%. That caused market commentators to hastily re-think their view the magic 3%.
Miton’s multi-asset team prefer not forecast, pointing to others’ failure to identify a tipping point as a reason why. “A lot of people we respect were saying not that long ago they expect 3% before the end of the year,” says fund manager Anthony Rayner. “Now, they’re moving that forward a little bit.”
The US yield curve can have predictive powers over economic recessions. But it can also signal a stock market downturn – as a higher yield draws investors back into bonds and out of equities.
“There’s no doubt in my mind that at some point that 10-year Treasury yield number is going to be very attractive to investors,” says Fahad Kamal, senior market strategist at Kleinwort Hambros. There will come a point, he adds, where, after a nice, long rally in equities, investors become willing to opt out of stocks and keep their cash in a relative safe haven offering a real return.
Why Invest in US Government Bonds?
US Treasuries are the most likely candidate for this. Underwritten by the US Government which has one of the best credit ratings around, T-notes are widely seen as a very low-risk investment.
But, while Kamal says this will “probably be the tipping point of this bull market”, he doesn’t think it will happen soon. And he certainly believes the number is going to be significantly higher than 3%: “I think it’s closer to between 4% and 5%.”
First, he explains, the 10-year yield should be equal to its growth rate plus its rate of inflation. For the US, that is 3%; the approximate GDP growth rate, plus 2%; its target CPI figure, which gives a yield 5%. Second, Kamal says in order for bonds to be compelling they have to yield more than stocks’ earnings growth – which is currently around 5.2%.
“Undeniably one of the big pillars of this bull market has been the fact that there is no alternative to equities. Some people will say at 3% there is an alternative; I don’t,” he continues.
Kamal says it is not unthinkable that the yield will reach the 4% to 5% level, but there’s still a long way to go yet. “And you certainly don’t want to hold these assets while the yields are going up because you’re guaranteed to lose money.”
David Jane, Rayner’s colleague at Miton, agrees. The market clearing level for the US 10-year Treasury should be around 4.5% based on old norms. “That’s a hell of a long way higher from here,” he says.
Rising Inflation Fears
The spectre of rising inflation in the form of jobs numbers recently caused a global stock market sell-off – the first slump of that magnitude in nearly two years. While some still think severe inflation is unlikely to materialise and that new Fed Char Jerome Powell will continue to raise rates slowly, last week’s US CPI data gave them pause for thought.
The data surprised on the upside, with a core figure of 1.8% that was above the forecast 1.7%. Clearly, a speedy path to higher inflation would be negative for bonds, meaning yields rise and prices fall.
The reaction of stock markets to the data surprised Kamal. Initially, markets in Europe that were open at the time fell off a cliff as soon as the numbers came through. However, by the end of the trading day, they had recovered. And the US market finished the day higher than where it started.
Kamal says it’s “inexplicable that markets found that to be another cause for celebration”. He adds that he has no explanation as to why markets recovered so quickly: “There’s clearly a lot of sentiment on the side-lines about buying the dip and it was an opportunity for some people.
“And, clearly, the robust economic backdrop makes many investors believe any dips that occur is an opportunity. That’s probably the best explanation I can give you; I don’t know if it’s the right one.”
In all probability, consensus seems to be that we’re heading into a higher inflation period. That might go some way to explaining why the inflation print last week failed to move markets meaningfully.
Jane and Rayner both believe this is the wrong way ton respond to what’s going on right now. “I think fund managers need to get with the programme,” says Jane. “[hey think ‘own long duration bonds and everything will be alright in the end’, but it definitely won’t; the world has changed.”
Rayner adds that fund managers don’t seem to know how to respond to this new environment. “They are buying index-linked bonds because they think if inflation goes up they will benefit. What they don’t realise is that if nominal yields go up more than inflation expectations go up then it won’t help them.”
