Too Hot to Handle?

As financial markets adjust to this tug of war between stronger economic growth and rising bond yields, bouts of volatility may persist for some time. However, the dominant theme of “going cyclical for the recovery” will likely remain in play for some time.

The Week in Review

Fed Chair Jerome Powell testified before Congress. In his testimony he downplayed the prospect of inflation saying that risks still lie to the downside and that he believes that it may take more than three years for sustained inflation to hit the Fed’s target. Both the equity market and the bond market initially seemed relieved by his comments, but then Treasury yields spiked as an auction for 7-year U.S. Treasuries fell flat with little demand. Importantly, both nominal and real yields did retrace much of that intraday move. Chair Powell is expected to speak at a Wall Street Journal summit this Thursday.

Vaccines continue to be rolled out. In the United States, 76.9 million doses have been given with almost 8.0% of the total population having received two doses. The pace of vaccinations has picked up over the last week with about 1.8 million vaccinations being performed each day. At the current pace, about 75.0% of the U.S. population could be inoculated in about 7 months. Separately, a third vaccine gained Food and Drug Administration (FDA) approval with the company saying that it could potentially provide 100 million doses of vaccine by June and up to a billion doses by the end of 2021. All three approved vaccines are highly effective at reducing serious illness and death.

Too Hot to Handle?

Bond yields at the longer end of the curve have risen sharply as investors look for signs of inflation amid a strengthening economic backdrop and expectations for significant fiscal stimulus from Washington. Between January 27th and February 25th, the 10-year U.S. Treasury yield rose just over 50 basis points (0.5%) from 1.01% to 1.52%. This is a material rise in a relatively short amount of time.

The speed at which such changes occur (or velocity) is often more important than the level of change as investors in various asset classes must rapidly adjust their portfolios to account for the higher range of bond yields. The MOVE index (the bond market’s proxy for volatility) jumped from 44.2 on January 27th to 74.2 on February 25th. While this may sound dramatic, the MOVE index surged from 58.2 at the end of 2019 to 163.7 on March 9th as the pandemic took hold and the 10-year U.S. Treasury yield plunged from 1.92% to just 0.54%. What we are seeing is not that. It is likely more benign and largely reflects investors’ expectations that the U.S. economy may be starting to heat up (first quarter real U.S. gross domestic product is tracking above 10.0% according to the Atlanta Fed, see figure 1).

This line chart shows the forcasted upward trend for the Atlanta Fed's GDPNowcast for 1Q21 (%, Left) and 10 Year U.S. Treasury Yield (%, Right) from January 29th to March 5th 2021

Some modest inflationary pressures may indeed be in the pipeline, but that has yet to be confirmed. In fact, the latest print on the personal consumption expenditure (PCE) deflator, which is the Fed’s preferred measure of inflation, actually showed just a 1.5% year-on-year increase in January. Well below the Fed’s average inflation target effects (meaning the data will be compared to last year’s data when the economy was in severe lockdown) and rising commodity prices, but we are not expecting to see runaway inflation. Perhaps the PCE deflator climbs into a range of 2.0% to 2.5% in the second quarter of 2021 (see figure 2). The real question is whether or not this pace of inflation will be sustained. It’s reasonable to think that inflation may run above 2.0% for some time given the amount of stimulus being proposed, but the notion of destructive inflation, where the economy overheats due to people buying more than they need to avoid tomorrow’s higher prices seems exaggerated. Such a discussion would seem more appropriate if the Fed’s monetary policy were to stay easy AFTER the economy has fully recovered, but that is not likely to be the case.

This line chart shows the ISM Manufacturing Prices Paid Index (Left) and PCE Price Deflator (Year on Year %, Right) from 2008 to 2022

In our view, a 10-year U.S. Treasury yield in the range of 1.50% to 2.00% may be possible, but we think that such levels can eventually be digested by the equity market. After all, we are likely just beginning a new economic cycle with double-digit gains in corporate earnings likely in both 2021 and 2022. However, as a major beneficiary of low yields and the “stay-at-home” economy, the Technology sector was poised for consolidation amid stretched valuations. In contrast, unloved sectors of the stock market that are positively correlated with higher yields like Energy and Financials are finally seeing some love as belief in the recovery broadens (see figure 3).

This chart shows the total return for the various S&P 500 sectors (Since January 27, 2021). Data shown indicates Information Technology at -1.4%, Consumer Discretionary at -3.2%, Communication Services at 5.4%, Materials at 5%, S&P 500 at 2.3%, Healthcare at -0.6%, Consumer Staples at -1.4%, Industrials at 7.3%, Real Estate at 2.7%, Utilities at -3.7%, Financials at 13.6%, and Energy at 22.9%.

Moving forward, all eyes will remain on Fed Chair Jerome Powell. Investors will look for any backtracking from their dovish stance and accommodative policy now that real yields on the 10-year have climbed to minus 0.7%. Citi’s economists have expressed doubt that the Fed will feel obligated to push back against the market’s stance that policy may end up taking a more hawkish down the road (in late 2022 or early 2023) than currently advertised. Citi’s Chief Global Equity Strategist Robert Buckland believes that a nominal 10-year U.S. Treasury yield in the range of 2.0% or a real 10-year U.S. Treasury yield of 0.0% would likely be necessary before the Fed would step in with some form of yield-curve control (long-duration bond purchases). The most likely guidance that should be expected from the Fed in the near-term is that it expects to remains extremely accommodative until substantial further progress has been made in the economic recovery, particularly in the labor market. Importantly, the February employment report will be released this Friday and could be a market-moving data release with Citi’s economists looking for 410,000 jobs to be added during the month.

As financial markets adjust to this tug of war between stronger economic growth and rising bond yields, bouts of volatility may persist for some time. However, the dominant theme of “going cyclical for the recovery” (meaning to tilt one’s exposure toward stocks that benefit from higher growth and a steeper yield curve) will likely remain in play for some time with Financials, Industrials, and Energy looking like the clear beneficiaries amid the current backdrop (see figure 4).

This chart shows how the following Industrial sectors correlate against the Real 10-Year Tresury Yield with the Financials and Technology stocks sitting on opposite ends of the interest rate sensitivity: Banks, Diversified Financials, Energy, Insurance, Capital Goods, Transportation, Consumer Services, Automobiles & Components, Materials, Food Beverage & Tobacco, Telecommunication Services, Real Estate, Utilites, Pharmaceuticals & Biotech & Life Sciences, Consumer Durables & Apparel, Food & Staples Retailing, Health Care Equipment & Services, Household & Personal Products, Media & Entertainment, Retailing, Semiconductors & Semiconductor Equipment, Commercial Services & Supplies, Software & Services, Technology Hardware & Equipment

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