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One of the years the largest increases in treasury bill yields prompt investors to map the impact of rising rates on markets ranging from stocks to corporate bonds.
The renewed optimism over US stimulus talks pushed the benchmark 10-year yield to a high of 0.94% on Tuesday, a move that, if continued, could trigger a domino effect on risky assets trading at record highs thanks to low interest rates. The question is whether the surge in yields is accompanied by an economic recovery and subdued inflation levels that would allow the Federal Reserve to keep rates low.
So far, it seems investors are positioning themselves for this scenario, with the Treasury curve – often an indicator of growth expectations – steepening overnight and US stocks climbing to a new high. Ten-year breakevens – a measure of market inflation expectations – hit their highest level since May 2019.
“A range of 1% to 2% is certainly possible and it would have broad implications on everything from emerging Asian currencies to commodities,” said Vishnu Varathan, head of economics and strategy at Mizuho Bank Ltd. in Singapore. “It’s probably a question of when – not if – yields are going to go up.”
Benchmark yields have tripled from their March lows on bets of a global economic recovery and a ‘return to normal’ of the pandemic using vaccines. A Bank of America survey last month found that a record 73% of investors expected a steeper yield curve.
Here’s a look at what higher Treasury yields could mean for different asset classes:
Soaring stocks
Stocks, especially those most exposed to a recovering economy, could be one of the clearest winners from a slight rise in Treasury yields. The MSCI AC World Index is already trading at an all time high and the rotation to cyclical stocks such as industrials and materials accelerated last month.
“As yields rise, inflation expectations are likely to be higher,” said Andrew Sheets, multi-asset strategist at Morgan Stanley. “The times when yields were going up and the yield curve was steepening – these are some of the best times for the stock market.”
But the key to the bullish outlook for equities is that inflation remains under control and economic growth returns. A return to the dreaded 1970s stagflation, for example, would quickly derail any recovery in risky assets.
“You can’t rule out a return of inflation – it could wash over us until 2021, 2022,” said Stephen Miller, advisor at GSFM, a unit of Canada CI Financial Group. “Yields will rise further and it will be more difficult for central banks to control their yield curves, which will certainly create headwinds for stocks and make them vulnerable to a reasonably significant correction.
No fear for EM
While higher yields on Treasuries have traditionally triggered a selloff in emerging market bonds and currencies, 2021 could be different, strategists say. Because the recent rise is linked to improved economic prospects, it is also positive for developing countries, said Khoon Goh, Asia research manager at Australia and New Zealand Banking Group Ltd. in Singapore.
“With the Fed supposed to maintain its very accommodative policy for a while, there is nothing to worry about for EMs at this point,” Goh said.
Indonesia, whose 10-year bond yield fell to its lowest level in 2018 last month, is a case in point, as investors grabbed higher-yielding, growth-sensitive assets. The rupee is also Asia’s best-performing currency over the past month, rallying over 3.6% against the dollar.
Most Asian currencies are also expected to “face a limited impact or even strengthen against the dollar,” said Mitul Kotecha, senior emerging markets strategist at TD Securities in Singapore. “Higher US yields could reflect a stronger US economic outlook, which would be good for Asian economies, but less favorable to the dollar.”
Gold Hold
The outlook is a little less certain for gold.
If an increase in Treasury yields to 1% or more “is due to a reflation operation, then the inflation thresholds – gold and gold, commodities, will generally do well”, according to Sophie Huynh, strategist at Société Générale SA .
But further yield gains could also hurt the gold as demand for safe-haven assets declines, according to Ken Peng, head of Asia investment strategy at the private banking arm of Citigroup Inc.
“Let’s say we’re going 1.5% on the 10-year yield, so you’re likely to see gold below $ 1,800, closer to $ 1,700,” Peng said. Gold traded around $ 1,810 on Wednesday.
Credit Bonanza
Just like stocks, the credit market could also benefit from higher yields on Treasuries.
Debt investors demand longer-term U.S. corporate bonds as stimulus spending builds risk appetite, making spreads on notes maturing in 10 years or more the tightest since February.
Credit spreads are expected to remain tight as long as the rise in Treasury yields is due to a reflation swap, SocGen’s Huynh said.
Dollar Hit
Higher Treasury yields could end up weighing down on the global reserve currency.
If the US yield curve steepens as inflation expectations rise, “it will encourage investors to hedge in currencies,” Citigroup Inc. strategists, including Calvin Tse, wrote in a recent note. Measures taken by investors to hedge against currency fluctuations in U.S. investments could cause the dollar to fall by as much as 20% next year, they said.
James Ashley of Goldman Sachs Asset Management, who also sees the potential for a steepening of the curve, forecasts a weaker dollar against emerging currencies such as the Chinese yuan.
Fed reaction
Still, a lot will depend on the Federal Reserve’s response to any spikes in US yields, particularly in the context of debate on its asset purchase program and the expectations it will leave to the economy make hot.
The Fed currently buys about $ 120 billion worth of treasury bills and mortgage-backed bonds each month, in part in an attempt to lower borrowing costs for businesses and households.
Longer-term bets on Treasuries and their ripple effects on other asset classes may depend on “how the Fed communicates,” Citi’s Peng said. “There is a tremendous amount of inertia in terms of positioning that has prevented higher returns – it’s good when we’re in a recession, but not when we’re in the proper recovery mode.”
– With the help of Liz McCormick
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