Liquid markets

Liquid markets

Martial artist and movie star Bruce Lee famously summarised his philosophy as “be water”. He meant that adaptability is a key skill (“be formless, shapeless, like water”) and that the same thing can have different effects depending on how sudden, fast the movement is (“water can flow or it can crash”). The rise in bond yields is just like this. If it happens alongside a pickup in growth with no central bank tightening – our view – it’s ultimately a positive for cyclical assets. The ride may be bumpier at times and the rate rise can overshoot, but the environment is constructive. If it’s driven by expectations of a persistent inflation spike and rate hikes – which we don’t see as likely – then it’s a negative especially if it happens very quickly, as macro and market conditions can’t adapt. While more rapid than expected, we think the rise in yields is directionally in line with our forecast of economic improvement. The overall backdrop does support risk-taking. But, for emerging markets, things get more challenging when core rates shift higher.

Level versus speed of yield rise: The current level of rates is still relatively low – taken in isolation, it’s unlikely to be a major headwind in terms of its contribution to any tightening in financial conditions. And, so far, the US dollar hasn’t strengthened that much, while the impact on credit spreads has been quite contained. However, equity risk premia have compressed in recent weeks: the US 10-year yield is now on a par with the S&P 500 dividend yield. The pace of the move higher in rates has been a more significant headwind. Yields have risen fairly rapidly for weeks and we think it’s also the speed of rate increases – not just the absolute level of yields – that matters for market performance.

Real rates versus inflation expectations: Prior the latest rise in rates, we saw an increase in breakeven inflation for quite a while, keeping real yields anchored at very low levels. Of course, this has been a supportive backdrop for most assets. But, although they still are in negative territory, real yields picked up while breakeven inflation stayed flat lately. This combination tends to be tough for assets that underperform when rates rise – similar to the ‘taper tantrum’ in May 2013. Markets are now expecting almost three Fed rate hikes by end-2023. To us, this expectation seems too hawkish, especially as any inflation spike should be short-lived. We see only one hike – in 2.5 years from now.

Here’s why this matters:

Cyclical rotation | Still in play: We believe that the rise in US yields is happening because of stronger growth and temporarily higher inflation. As such, we think it’s a positive for markets, especially as we don’t expect central banks to hike rates for now. We remain pro-risk in our tactical asset allocation and, generally, prefer cyclical assets that outperform when growth accelerates. We think we are well positioned for a continuation of the recovery and reflation trade, supported by a pickup in activity from this spring as economies reopen. We still expect real rates to stay in negative territory for the next several quarters – which is stimulative – and then remain at what we labelled the ‘eternal zero’ for some time. With front-end rates anchored, the yield curve should steepen from here.

Emerging markets | Pressure point: The pace of increase in US 10-year yields (about 50 bps over four weeks) exceeds the ‘pain threshold’ of 20-30 bps per month beyond which EM assets typically struggle. And the US rate increase is mostly driven by higher real rates – not by a further pickup in inflation expectations. Despite the move higher in core rates, though, most EM asset classes have emerged only bruised, not battered. Comparing EMs across many dimensions, Asia has the strongest fundamentals – but it’s also the EM region where equity valuations look more challenging, although this may partly reflect structural shifts towards higher growth sectors – while Latin America shows a range of vulnerabilities. Exporters of commodities, at this stage, benefit from rising commodity prices.

Meanwhile, watch central banks and inflation…

European Central Bank versus yield rise: The ECB meeting this Thursday may reveal how much pushback there is to the rise in bond yields. After some verbal intervention, the central bank could now stress that it has room to use its asset purchases to lean against any unwarranted yield rise. US inflation may be key this time around, even more so after last week’s jobs report surprised to the upside. While we expect inflation to temporarily move higher over the next few months, any surprise could impact the market’s view on the Fed reaction function and bond yields – which may also be impacted by the likely approval of Biden’s $1.9 trillion fiscal package over the next few days. We see a phase of consolidation in the bond market at some point, but an improving outlook does imply higher yields over time. China’s congress may reveal news for sectors such as defence and tech, and on sustainability.

Daniele Antonucci | Chief Economist & Macro Strategist

This document has been prepared by Quintet Private Bank (Europe) S.A. The statements and views expressed in this document – based upon information from sources believed to be reliable – are those of Quintet Private Bank (Europe) S.A. and are subject to change. This document is of a general nature and does not constitute legal, accounting, tax or investment advice. All investors should keep in mind that past performance is no indication of future performance, and that the value of investments may go up or down. Changes in exchange rates may also cause the value of underlying investments to go up or down.

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