U.S. bond yields are on the rebound, putting pressure on equities and raising concerns about the end of a very long bull cycle.
The TSX, the S&P 500 and global equities were all hit last week, with each dropping around 4%, says a Richardson GMP market report, and the declines continued on Monday.
Is it bye-bye bull run and voilà volatility? Reports from Richardson GMP, BMO and BlackRock provide some context.
Noting recent solid earnings, strong global growth and relatively low geopolitical risks, the Richardson GMP report says the weakness in equities can be almost solely attributed to rising bond yields.
Last week the U.S. 10-year saw an 18-basis-point increase to more than 2.8%—a four-year high, says BMO chief economist Douglas Porter in a weekly financial report. (The 10-year Treasury is currently at 2.84%.) Yield on the 30-year hit more than 3% last week.
The year-to-date rise for the U.S. 10-year is more than 40 basis points. “Similar maturities in the U.K. and Mexico have matched that pace, followed by plus-30 [basis-point] increases in Canada, Germany and even Switzerland,” says Porter.
The implications of those higher yields are being felt broadly in equities.
The pullback in equities hasn’t been driven by the interest-sensitive sectors, even though they had lagged in January, says Porter. “Instead, the main areas of weakness were in energy and materials, both with roughly 5% declines, while the previous high-fliers of tech and healthcare were next hardest hit.”
However, the Richardson GMP authors are unequivocal about the near-term future of equities: “We don’t think this recent weakness is the end of the bull cycle, as many of our market cycle indicators remain positive,” they say. “However, if we had to guess how this market cycle does end, […] it will be at the hands of higher bond yields.”
While 2.84% is hardly high yield, “given the amount of [quantitative easing] over the past decade, the pain point for higher yields may be lower than most would normally expect,” say the authors.
Where higher yields will hurt
For example, if quantitative easing combined with lower yields has inflated asset prices, the removal of quantitative easing plus higher yields could do the opposite.
“Central bank balance sheets went from [US]$4 trillion in 2007 to over [US]$14 trillion today,” the Richardson GMP report says. “Given that [US]$10 trillion helped inflate asset prices, the sensitivity to higher yields may be much lower than many expect. Perhaps we are seeing a hint of this today.”
Higher bond yields will weigh on other assets as well, such as real estate.
“If bond yields continue to rise on the back of better economic data, we could see broader asset prices fall,” say the authors. “This could cause the wealth effect and confidence to decline, circulating back to lower economic activity.”
Though that scenario could be quarters or years away, it’s probably the frontrunner for the end of the bull market, says the Richardson GMP report.
The role of risk appetite
Increasing U.S. yields and a hawkish Fed outlook provide support for the U.S. dollar, after a string of weekly declines. But that’s not how it’s playing out so far.
In a BlackRock report on the declining U.S. dollar, global chief investment strategist Richard Turnill says stronger risk appetite is behind the currency’s woes.
“Investors are ditching dollar safe havens to chase yield in emerging markets and returns in global equity markets,” he says. “We see risk-on rebalancing eventually ending, and yield spreads [between U.S. Treasurys and global government bonds] likely taking control again.”
Turnill is underweight U.S. Treasurys relative to emerging market and other global equities. “We expect rates to move moderately higher amid a sustained economic expansion and a tightening Fed,” he says. “Rising inflation and lower valuations give TIPS [Treasury inflation protected securities] an edge over nominal Treasuries.”
A closer look at what’s driving yields
- U.S. tax reform and “near-chaotic” spending are expected to increase the U.S. budget deficit. “It is unprecedented to have the U.S. deficit widening materially as the economic expansion matures,” says Porter.
- The Fed is decreasing its holdings, having dropped US$42 billion in the past three months, or 1% of its total. And quantitative easing by the Bank of Japan and the European Central Bank could be reduced in the near future. Says the Richardson GMP report: “Japan’s economy grew 2.5% in the latest quarter, and the Euro-zone is running at about 2.4% (annualized pace). Hardly paces that would warrant continued unprecedented monetary policy.”
- The market is nearly fully priced for three Fed rate hikes this year. “The risk is to the high side of that call,” says Porter. “In turn this has pressured two-year yields to a nine-year high above 2.15%.”
- Core inflation is currently trending higher globally, and expected to trend higher in the U.S. “The 10-year inflation breakeven rate for Treasuries is now above 2.1%, up almost 40 [basis points] from just last summer,” says Porter.
- Wage pressures are starting to emerge. For example, in last week’s U.S. payroll report, average hourly earnings increased to 2.9% year-over-year—the fastest pace since 2009. “There is a long- standing relationship (not shockingly) between wages and long-term bond yields,” says Porter, providing data in the BMO report.
- Global growth in on the upswing. “It’s not just inflation expectations at work, as real Treasury yields are also now up almost 40 [basis points] from last summer’s lows,” says Porter.
Porter’s year-end target for U.S. 10-year yields is 3.0%, and 3.4% for the end of 2019.
For those same timeframes, Porter forecasts 10-year government of Canada yields of 2.65% and 3.2%, respectively.
“The 3% threshold has not been cracked by 10s in nearly seven years, and even our relatively conservative forecast would represent an important step-up in yields,” he says.