• The continued improvement in economic growth prospects in the US has forced government bond yields to their highest levels since the start of the pandemic.

• The Federal Reserve has not hinted at an upcoming change in policy, but that has not stopped financial markets from expecting an earlier removal of monetary support.

• The upward trend on yields should continue as vaccinations pave the way for a strong growth rebound in the coming quarters.

• Elevated government bond yields continued to disrupt global financial markets. Equity markets rolled over and foreign currencies came under pressure. Foreign central banks have recently become more vocal and active in their effort to contain bond yields.

Economy gains traction with vaccinations underway

Economies have shown impressive resilience and data has consistently exceeded expectations since the pandemic began. With the beginning of mass vaccinations and the gradual reopening of economies, we are moving into a better growth environment supported by highly stimulative fiscal and monetary policies. This positive view is reinforced by leading indicators of economic growth rebounding to their highest levels since 2018. Moreover, as lockdowns and work-from-home orders curbed spending, many consumers accumulated savings throughout the pandemic and are now in a position to boost spending as virus risks fade. We look for a nearly symmetrical rebound in growth in 2021 from the deep contraction of last year.

New variants, elevated unemployment and inflation represent potential risks. We recognize a variety of risks continue to challenge our constructive outlook. New COVID-19 variants are spreading rapidly and, while the current vaccines are proving effective against these strains, it’s possible that certain mutations will be resistant, thereby delaying the return to normal. Unemployment also remains unacceptably high in most major nations as travel and leisure sectors of the economy are running well below capacity. However, in many places where consumers are able to spend, prices of goods are rising and could be pushed even higher as pent-up demand is unwound into the economy. Inflation pressures could mount in the near term especially due to low base comparisons with 2020 but, in our view, problematic levels of inflation are unlikely to be sustained.

Central banks committed to accommodative monetary policy. Against this backdrop, global central bankers have reiterated their commitment to maintain ultra-low interest rates for an extended period to support the recovery. In fact, even in the face of rising price pressures, the Fed’s new operating framework allows for inflation to rise above its 2% for some time to make up for periods spent below. As a result, we do not look for any short-term interest rate hikes over our 1-year forecast horizon.

Bond yields rise, alleviating valuation risk

While short-term rates are anchored at ultra-low levels, long-term bond yields are more sensitive to changes in the macroeconomic backdrop and they have been moving higher. Rising inflation expectations and the prospect of better economic growth pushed yields gradually higher since their early 2020 lows and that trend accelerated in early 2021.

A battle of the yields is underway as the returns on long-dated government bonds recover to pre-pandemic levels, undermining the allure of riskier assets such as stocks. The rally in bond yields is being led by US Treasuries, as the American economy shines the brightest in the Western sphere. However, while the US dollar got an unexpected leg up from the early stages of the surge in Treasury yields, the strengthening vaccine-led optimism is now spreading to other parts of the world, boosting yields globally. Does this mean the extreme bearish bets against the dollar late last year were justified, or is there hope yet for a full comeback?

Global yields catch up with US Treasuries; has the USD’s rebound been thwarted?

Rising inflation expectations can have a two-way effect on a currency. On the one hand, they lift rate hike odds in futures markets, boosting long currency positions. On the other, they negate the yield advantage stemming from higher nominal yields by depressing real yields, therefore reducing the attractiveness to hold that currency. For the USD, falling real yields appeared to play a more important role in late 2020 following Biden’s presidential win when inflation expectations were edging up faster than nominal yields.

However, in January, the rally in Treasury yields completely took off, bringing an abrupt end to the dollar’s selloff, and the Fed’s efforts to curtail expectations of an early tapering in asset purchases were only able to temporarily hold down long-term yields. The rapid rise in yields began with the failure of the Treasury’s auction of 7-year notes. Expectations are that inflation would make a comeback as demand growth as the scale of vaccination picks pace globally. A rising inflation would mean a reversal in the accommodative monetary stance of global central banks. The gush of liquidity has held global equity markets in good stead despite the limping world economy. Yet now that nominal yields are rising faster than inflation expectations, the greenback’s rebound is faltering and the dollar index has breached its shortterm ascending trendline.

US bond selloff spreads to other markets

While short-term rates are anchored at ultra-low levels, long-term bond yields are more sensitive to changes in the macroeconomic backdrop and they have been moving higher.

Rising inflation expectations and the prospect of better economic growth pushed yields gradually higher since their early 2020 lows and that trend accelerated in early 2021. The US 10-year yield tripled from its summer 2020 low, climbing above 1.50% and touched an intraday high of 1.626% for the first time since the pandemic began, with more than half of that adjustment happening year-to-date.

US yields continued to soar amid a record supply of new Treasuries in the bond market and growing optimism about America’s recovery. What’s changed this time for the dollar, though, is that sovereign bonds around the world have started to join the yield rally. The Australian 10-year yield reached its highest since May 2019, UK yields climbed towards the March 2020 spike and Germany’s 10-year yield approached the June 2020 peak when Europe was emerging from the first lockdown.

Source: BIMB Securities Research - 16 Mar 2021