COVID-19 – Some positive news amid the gloom
There has been encouraging news from the rollout of COVID-19 vaccines in Israel and the UK. In the UK, there are clear signs that hospitalisations and infections are declining among the control group being vaccinated. In Israel, the vaccine is reported to have reduced infections by around 89%. Meanwhile, in Europe, although new cases remain at elevated levels, they are showing signs of stabilising as the rollout of vaccines impedes progress and dampens infection rates.
Some doubts over the effectiveness of the vaccines in tackling new virus variants have arisen after it was confirmed that two of the drugs were not effective against the South African variant. It is probable that such variants are likely to contribute to continued tight border controls and depressed tourism.
Amid hopes of successful vaccine rollouts and shrinking COVID-19 cases globally, optimism is picking up. Economic surveys and Purchasing Manager Indices point to expectations about output rising to the highest level since March 2018, even though the current situation remains depressed.
The week’s big story – Rising real yields
Yield curves have continued to steepen with yields of the 10-year and 30-year US Treasuries hitting highs for the year amid greater implied volatility. The US yield curve has not been this steep since late 2016/early 2017. The yield of the 10-year Treasury bond, which began the year at around 0.9%, is now trading at around 1.35%.
Over the last week, the big story has been the rise in real yields. In the US, breakeven spreads fell despite supportive inflation data, leading to a sharp rise in the 10-year real yield (see Exhibit 1 below).
This rise in real yields triggered a sell-off in US stocks. In the sell-off, value companies, which should do relatively well in a reflationary environment, saw moderate gains; the losses were in growth stocks (e.g. the NASDAQ). Given that a greater share of tech earnings are in the future, the sector is particularly sensitive to interest rates.
Central bankers respond to rising bond yields
G7 sovereign bond yields have risen (from very low levels) so far this year. The move has been driven by market confidence that, despite initial problems, vaccines will end the pandemic. Pent-up demand should then fuel a strong economic rebound.
Having repeatedly insisted that they will act to keep interest rates low, the rise in bond yields prompted a number of reactions from central bankers. These interventions appeared to ensure that bond markets do not overreact to what are likely to be transitory rises in inflation over the months ahead.
- The Reserve Bank of Australia said on Monday that it is resuming bond buying after a two-month pause. The announcement followed a rise in 10-year bond yields by around 50bp in recent weeks. Yields of 3-year bonds had also risen to above the 0.1% targeted by the central bank. Initially the RBA’s measures brought yields down, but they remain elevated compared to their target.
- In the eurozone, a rise in the yield of the 10-year German Bund to -0.3% was enough to prompt an intervention by President Christine Lagarde of the European Central Bank. She told the European parliament that the ECB would maintain favourable financing conditions throughout the pandemic and monitor the evolution of longer-term nominal yields. Yields of the 10-year German Bund fell in response. The ECB has already made it clear that it would not be comfortable with an unwarranted rise in real yields that could tighten financial conditions – very much a key focus for the ECB.
- Yesterday, US Federal Reserve Chair Jerome Powell gave a downbeat assessment of the state of the US economy in his semi-annual monetary policy report to Congress. In particular, Powell played down risks of a spike in inflation, saying that inflation dynamics did “not change on a dime” and that “there really hasn’t been lately” a strong connection between budget deficits and inflation. He highlighted the slack in the labour market, with nearly 10 million fewer Americans employed compared with a year ago, as one of the most worrying aspects of the US economy.
Chair Powell’s testimony bolstered the valuations of growth stocks. The NASDAQ Composite, which before the testimony had fallen to a level around 7% below this month’s high, retrieved a lot of lost ground, while broader indices gained for the day. The sharp rise in bond yields came to a halt, at least for the time being.
In the US, Congress continues work on the next relief package. The guidance is that President Biden should sign the bill before the current unemployment supplements expire on 14 March. The baseline forecast is for a package of USD 1.0-1.9 trillion passing in early March.
In spite of the recent rise in real yields, financial conditions have remained supportive of risky assets. Moreover, a rise in real yields due to improved growth prospects as well as higher inflation should buoy earnings and support equity market valuations. Earnings have so far surprised to the upside with S&P company earnings surprises up 18.1%, with earnings growth of 5.5%.
Inflation may spike higher in the short term, reflecting a combination of base effects, supply disruptions and a potential miss-match between the speed at which demand returns for some goods and services and the ability of firms to restart production.
As such, it is possible we see ongoing upward pressure on the 5-year and 10-year inflation breakeven rates. This would drive a steepening of government bond curves. Events this week, however, show that central banks stand ready should activity in bond markets become disorderly.
A more persistent increase in inflationary pressures will take longer to build, particularly in the eurozone. However, it is probable that a combination of a closing output gap, rising inflation expectations and continued policy accommodation will deliver reflation over the medium term.
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.
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