Are the bond vigilantes back?

Not long ago we talked about how we felt that inflation fears were overdone. We gave examples that included our concern about spare capacity in the developed economy, how the Fed remains fearful about growth prospects, and about how the acceleration towards a global digitalised economy that we have witnessed throughout this pandemic may not be as inflationary as post crisis growth patterns have been in the past. We also argued that governments will need to make a plan to claw back some of the spending that they have embarked on to see their economies through this crisis. Finally, although inflation is rising, core inflation is rising more slowly that headline inflation, and while a boost to inflation is expected in the coming months as we emerge from lockdown, this may not last. Thus, policy makers may not be too worried about rising inflation rates in the near term, and higher levels of inflation may not lead to a faster trajectory of interest rate rises in the western world. 

Panic in the bond market knocks confidence, slightly 

While we stick by these views, there has been a growing panic in the financial press about the sharp rise in Treasury yields and the prospect of an “inflationary bubble” that could wreak havoc on highly valued stock markets, and tech stocks, in particular. The factors that are driving these concerns include President Biden’s $1.9 trillion stimulus package, which is moving forward and could pass in the House by the end of this week. The key features of the package include direct payments to households, extra money for the states and local government to make up for lost tax revenue, provision for unemployment benefits, aid to help reopen schools, aid for coronavirus testing, spending on metro transit systems and an increase in the Federal minimum wage. While this is all worthy spending, bar the direct payments to households and the transit spending, the rest seems to be filling gaps left by the coronavirus, thus, this White House spending package may not be as inflationary as some expect.

How fast will growth return?  

Another driver is the prospect of a quick return to growth once lockdowns end and the coronavirus is back under control through mass vaccination programmes around the world. While we expect growth to pick up sharply, this step up in pace of global growth is not going to be sustainable. In Europe and the UK, in particular, where lockdowns have been harsh and long, the pickup in growth in the coming quarters is making up for growth that has been lost during the pandemic. In the US, the pickup in growth is expected to come from the White House spending package. As we mention above, we do not think that this package will supercharge growth, although it could have a short-term impact on consumption rates due to the direct payments of $1,400 sent to each tax filer and dependent, although the payments would start to phase out at an individual income of $75,000, which is a fairly low threshold. 

Commodity prices are red flag for inflation 

Commodity prices are likely to filter into inflation around the world. Oil prices are back to their pre-pandemic level, and Brent crude is close to its pre-pandemic peak above $68.00 per barrel reached in January 2020. Above this level, then $80 per barrel, the high from September 2018, comes into focus. Copper prices have surged, as have food prices including corn. So, we had better get used to spending more on our staples, including energy and food in the coming months. This will no doubt boost headline prices and put pressure on the inflation pipeline in the coming months. However, later in the year, rising prices could come back to bite consumer demand. For example, rising prices combined with slow employment growth - we have yet to see a surge in employment and jobs growth in the US this year, although we look forward to assessing the state of the US labour market when the February numbers are released early next month – are not sustainable bedfellows in the long term. 

Why it’s worth watching gold before ditching risky assets 

Interestingly, the gold price, which is considered a hedge against inflation, has not surged in line with rising inflation concerns that have sent some panic through the bond market. The gold price is around the $1,800 mark, and although it has picked up this week, it has not matched the gains made by the US Treasury yield, which is up 10 basis points this week. The 10-year benchmark Treasury yield did breach the 1.4% level earlier on Wednesday; however, it has since pulled back to the 1.38% mark. While we note that this is a large move for Treasuries, we would argue that the nominal level of yields remains low, real yields (when adjusted for inflation) will also remain low, the Federal Reserve remains unlikely to raise interest rates any time soon, and the only people who seem genuinely worried about inflation are either 1, old, and remember the 1970S, or 2, detached from the real world. Many people in finance can sit in their plush homes during this pandemic and not have any clue what people who have lost their jobs, or are expected to, feel about their financial situation and consumption, especially when food prices are set to rise sharply. Diatribe over, but we continue to think that fears about rampaging inflation are overdone and that the sell-off in bonds (yields move inversely to bond prices) will calm down. We will, however, reassess our view if US 10-year Treasury Yields rise above 1.6% in the next couple of weeks. Also, if you own bonds, we do expect you to see further declines in bond prices, although we don’t think that the downtrend will be long lasting. 

Rising bond yields and stocks, what next? 

So, where does this leave stocks? The Nasdaq is where fears of rising inflation will likely hit home the hardest. However, the Nasdaq remains close to a record high, and although it looks like it could have peaked, we need to see more evidence of a decent sell off before we get too negative on the tech sector. We would argue that tech will be sensitive to rising treasury yields, and if we see yields surge towards 1.6%, as mentioned above, then we could see big falls in tech stocks, both large and small. Rising interest rates are bad news for tech stocks, especially if companies have low or negative profits, since it reduces their discounted future profits that drive their equity valuations. If yields rise sharply and if tech sells off, this is when we could see value stocks come back into play. This could also be when we see the FTSE 100 start to outperform after a torrid year. If rising yields and inflation expectations continue to dominate markets then other unloved stocks could also come roaring back; is this why GameStop’s share price rose more than 100% on Wednesday? Adding to the volatility as we move to the end of the week could be another torrent of reddit-inspired retail traders, so beware of rogue moves in markets in the next few days. 

What to watch for in FX 

While the outlook for stocks remains murky, FX trends are quietly gathering momentum. The Aussie dollar hit its highest level for more than 3 years vs. the USD earlier, while GBP/USD is powering ahead and testing $1.4150. Cable is at its highest level since April 2018, and the next key resistance to watch is $1.4250 ahead of $1.4650 – the high from before the Brexit vote in 2016. Thus, if the pound keeps powering ahead, driven by a powerful combination of Britain’s vaccine success, political woes for Nicola Sturgeon in Scotland and expectations of a strong bounce back in growth later this year, then, for the pound at least, it may seem like Brexit never happened.