In our view, there are several reasons for the rise in US Treasury bond yields. Here are the factors we think should be taken into account:
Rising oil prices drive break-even inflation rates higher
To start with, both break-even inflation and real interest rates rose in April.
Market-based inflation expectations were supported by higher reported US core inflation in March and by higher oil prices (see Exhibit 1).
After several months of subdued readings, data published in April showed US core inflation rising to above 2% in March, whereas West Texas Intermediate (WTI) oil prices rallied to USD 68 a barrel supported by strong demand and geopolitical concerns around Iran.Exhibit 1: Rising oil prices are supportive of US market-based inflation expectations (i.e. the breakeven inflation rate) Source: Bloomberg, BNP Paribas Asset Management, as of 30/04/2018
Rising US Treasury bond yields: supply concerns
In addition, markets appeared to be increasingly concerned about the supply of US Treasury bonds that will be needed to finance the Trump administration’s fiscal expansion. Such issuance concerns had already hit the market during the first quarter and it is likely that they will continue to push US bond yields higher.
Gradual and steady rise in US official rates to continue
Beyond these supply concerns, recent US macroeconomic data has been solid enough to convince the market that the Federal Reserve will continue raising interest rates in a gradual and steady way.
We do not see higher US rates as an impediment for a continued equity market rally. Indeed, as we discussed in the March Asset Allocation monthly, it is quite normal to see strong equity performance during Fed tightening cycles.
It's earnings growth that is supportive for equity markets
What changes is the drivers of the outperformance, with earnings growth doing most of the legwork rather than price/earnings multiple expansion. In other words, as long as the growth backdrop is supportive (as it is now) and the rise in bond yields is contained, any equity corrections should be limited. Therefore they can be seen as buying opportunities.
First quarter earnings growth has been impressive
The latest US growth data was not spectacular: in first quarter of 2018, GDP grew by 2.3%, down from 2.9% in the fourth quarter of 2017.
However, it is too early to worry about a turn in the US economic cycle. If anything, the first-quarter earnings season has been encouraging, with 77% of companies beating analyst earnings estimates (among the 32% that have reported results so far).
This article, first published on 2 May 2018, is an extract from MAQS Asset Allocation Monthly - May 2018