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Fixed Income is grabbing the headlines – in particular the upward march of global bond yields led by US Government bonds i.e. The US 10-year Treasury bond has moved from a 0.90% Yield-to-Maturity in December to 1.50% today with a ‘flash crash’ to 1.61% Thursday last week. This represents one of the worst yearly starts for Fixed Income for several years.

Why has it happened?

A number of factors:

  • A belief that the worst of the Covid-19 crisis is behind us with a global vaccination programme in full roll-out paving the way for economic recovery
  • This recovery supported by an imminent $1.9 Trillion fiscal stimulus programme from the new Joe Biden administration
  • The stimulus package on top of 12-months of fiscal stimulus from Central Banks around the world
  •  Stronger economic growth is predicted but so is a rise in inflation – something that has been absent in the Western World for essentially a decade. US Treasury Inflation Protected Securities (TIPS) are predicting inflation will average 2.2% each year for the next 10 years.

Inflation of course erodes the real value of bonds!     

Why are higher bond yields a problem for stocks?

Three reasons:

  • Higher bond yields make investment in Fixed Income relatively more attractive versus stock market investments
  • Higher yields raise the cost of borrowing for companies meaning lower profits e.g. If IBM has to pay 4% interest rate/coupon/yield to issue its bonds rather than 1.5% – that makes difference!  
  • Analysts decide whether a stock is cheap or dear using valuations often discounting estimated future company earnings. Those future earnings are discounted more heavily in a higher interest environment resulting in lower present-day valuations

So, US (global) equities are nervous especially considering they are trading at an all-time high!

The questions are:

  • Will inflation resurface (only time will tell)?
  • At what level of interest rates is that a problem for the stock market – is it a 1.75% Yield-to-Maturity or 2.25% or 2.75% (only time will tell)?

How have other asset classes responded to stronger economic prospects?

Commodities normal rally with any economic upswing: Indeed, Oil is trading above $60 a barrel (Brent Oil) having trading at $20 a year ago at the height of the economic crisis. Similarly, Copper and Nickel are at multi-year highs.

Gold does not know whether to go up or down!

Pulling it up is the threat of inflation with gold normally performing well in inflationary times as it holds its real value i.e. a bar of gold is worth a bar of gold no matter what inflation is.

Pulling it down is a) the threat of the 2020 financial crisis is very much receding and b) gold becomes less attractive as a means of investment (paying no interest) as bond yields become more attractive as a home for investment.

As a result, gold is well below crisis highs of $2,050 per ounce at $1,720.

The US Dollar – The ‘Greenback’ is fairly weak with the DXY index having a 12-month range of 89.2 -103 and a DXY current value of 91.1. The biggest driver of a currency is the level of short-term interest rates and, although longer term bond yields are rising, the US Federal Reserve is committed to keeping short interest rates near zero and is prepared for inflation to overshoot on the upside.

Something to think about!

One of the best performing asset classes last year was US Treasury Inflation-Protected Securities (TIPS) at +35% for the year…the markets are telling us something!

Something else to think about!

The most important monthly economic data release in the world is US NON-FARM PAYROLL – the number of people in the US who secure jobs (excluding the farming sector) in any given month. February’s jobs data is released Friday March 5th – the market forecast is for 180,000 new jobs to be created. Watch out for the number as it will give a big clues as to the strength of the US economic recovery! Markets will react!