In the second half of March, yields on US 10-year Treasuries spiked above 1.7 per cent, hitting their highest point in more than a year and sending ripples of anxiety through stock markets.
The engine driving the rise in yields is clear: investors, having been buoyed by a hefty US fiscal-stimulus package and the vaccine roll-out in leading economies, now fear that life after Covid-19 will spell a vigorous return to growth accompanied by inflation.
But what do rising bond yields mean for equities in the longer term?
And could a potential uptick in inflation force an earlier-than-expected rise in interest rates that would quell growth and undermine the recent optimism in equity markets?
In late March, the US Federal Reserve said that it expected stronger growth than previously anticipated, with forecasts of 6.5 per cent for this year — up from predictions of 4.2 per cent last December. It also said that there were no plans to raise interest rates until at least 2023 and that it would continue with its bond-buying programme.
Yet the stakes remain high: years of low interest rates have led to soaring asset prices; a sudden jump in inflation would threaten to reverse that process, driving the economy back.
Tumbling house prices caused by a rise in interest rates could hit people’s wealth hard, dampening consumer spending.
Against that backdrop, Julian Chillingworth, chief investment officer at Rathbone Investment Management, is cautiously optimistic. He says that profits are likely to pick up with the economic recovery, which will support some of the more stretched valuations of late, particularly of cyclical stocks.
“You could argue that a lot of the good news on vaccinations and economic recovery has been priced in early, which could lead to a bit of a pause in the markets,” he says.
But overall we are not concerned for the year as a whole, and we continue to like equities.
Julian Chillingworth,
Chief Investment Officer at Rathbone Investment Management
Much rests on the outlook for inflation and the rate at which it rises. But Thomas Pugh, an economist at Capital Economics, argues that there are copious amounts of spare capacity in the US and UK economies, which will establish a cap on inflation.
He adds that central banks around the world have already signalled that they are more than willing to let their economies run a little hot in the short term in order to give more throttle to the recovery.
In the case of the UK, insists Pugh, that as good as rules out any move on interest-rate rises. “The Bank of England has already said that they’re going to be looking to see sustained inflation above 2 per cent before they even think about raising rates.”
One of the big unknowns in the expected recovery is the extent to which consumers will start spending again. Pugh points out that consumers in the UK, by and large, have used the pandemic and resulting lockdowns to pay down debt and accumulate savings.
Indeed, households throughout the UK last year repaid the most debt outstanding on credit cards and loans since records began almost 30 years ago; according to the Bank of England, the population repaid £16.6bn of consumer credit, the highest amount since at least 1993 and the first annual reduction since 2011.
“As an aggregate, consumers are in a really good position at the moment,” says Pugh.
When retail hospitality businesses reopen, there will be a big pool of cash available to spend.
Thomas Pugh
Economist at Capital Economics
Chillingworth at Rathbones agrees. But he argues that it is important for the government to make every effort to boost consumer confidence in the coming months given that the majority of disposable income following households’ debt reduction resides with wealthier families, who may not be in a particular hurry to rush out and spend money.
“People need to gain confidence in the recovery for the economy to benefit fully from the potential wave of consumer spending,” he says.
As long as that happens, the recent rise in bond yields is unlikely to spell any lasting repercussions for equities — at least not for the foreseeable future. As Chillingworth puts it: “There are some very interesting opportunities, both in the UK but also, thanks to the strength of sterling, in the US.”