Rising bond yields: what’s happening – and does it matter?

Bondholders have been selling, causing bond prices to fall and their yields – the interest they pay bearers relative to their price – to rise. This isn’t unusual during periods, as now, when investors are anticipating a broad economic recovery.

The usual pattern would be a switch away from bonds and into shares, with equity investors hoping to capture a bounce-back in company earnings and profits.

This time round however, the backdrop is highly unusual. Shares in many quarters are already highly valued. This is in part because central banks – such as the Federal Reserve and the Bank of England – adopted draconian measures to support economies in response to the pandemic. So the issue of rising yields now is triggering other, related concerns, such as whether or not central banks might withdraw their support, something investors would view as distinctly negative. Overall these factors are contributing to volatility.

Rising bond yields 2021: a closer look

Our view coming into 2021 was that over the course of the year we could see a pick up in economic activity and growth as the distribution of vaccines accelerated, and restrictions were lifted allowing a return to more normal patterns of behaviour. This should provide a supportive backdrop for equity markets, particularly those more economically sensitive sectors and industries which suffered under the uncertainty and restrictions of last year.

As the risks of Covid subsided and investor sentiment improved, we further believed that government bond yields could rise from close to zero or negative levels as a result of expectations of a solid economic backdrop and rising inflation – in theory these are good reasons for yields to move higher. Historically real yields and inflation expectations rise together when investors expect a stronger, more sustained economic recovery, which should not be cause for concern for equity investors, as equity markets should rise given this backdrop.

So far this year, this scenario has largely played out. Whilst in the short term global economic data has been mixed as tougher restrictions in the first quarter have continued to impact activity in some parts of the world including the UK, the distribution of vaccines has gathered momentum, policy makers have remained supportive, and improvement in corporate earnings have broadened out from the technology sector, to more cyclical sectors including materials, energy and financials. Furthermore, headline inflation has shown signs of picking up, largely driven by a recovery in the oil price, whilst market expectations for future inflation have also risen.

So the question then turns to risk. Why are equity investors keeping such a close eye on the movements in government bond yields?

What are the risks?

There is something familiar about the jitters currently observed in markets. Since the financial crisis over a decade ago, which caused central banks to initiate a range of drastic measures, there has been anxiety about what might happen if central banks were to reverse these measures and withdraw some of their support. This market response has been dubbed “taper tantrums” – a reference to central banks’ use of the word “taper” to describe their gradual normalisation of policies.

^{Source: Bloomberg, Cazenove Capital, March 2021}

Firstly, there is an important distinction to be made between the level of yields and the pace at which they rise. The fact that the yield of US 10 year Treasuries has moved to 1.4% this year does not in itself pose a threat to equity markets. However, it is the rate at which they have risen that has caught investor’s attention. To 25 February, the one month change in 10 year US Treasury yields was 2 standard deviations above the long-term average¹. Historically, such rapid movements in yields in either direction have weighed on equity returns.

It is also important to understand how yields have moved. As it has been noted, higher yields when accompanied by rising inflation expectations are generally positive for equities, signalling a stronger growth outlook. Over the past couple of weeks however, whilst yields have risen, market expectations of inflation have not. This environment of rising real rates (or inflation-adjusted rates) is less positive for equities, suggesting the market is concerned about policy shifts from central banks. This could reduce the support which has been afforded to risk assets by highly accommodative monetary policy and likely result in a re-pricing of risk.

A common narrative this year regarding equity valuations has been that they look cheap when compared to historically expensive bonds. As yields rise and bonds start to look less unattractively valued, equities look increasingly expensive on a relative basis, particularly in growth sectors which have been the main beneficiaries of low rates and falling yields over the past few years. It has been these concerns around less compelling relative valuations and lower policy support which has largely been responsible for higher levels of volatility in equity markets in the short-term.

Our view, and how it informs our current investment positioning

We remain positive on the growth outlook for this year and next and recognise that we are likely to see headline inflation continue to rise, if only on a transitory basis. There is likely to be further upward pressure on government bond yields from here. While memories of the 2013 taper tantrum looms (when a suggestion of policy tightening by the Fed resulted in a spike in yields),  our base case at this stage is that monetary policy will remain accomodating and interest rates unchanged. This is a point which Jerome Powell from the US Federal Reserve, Christine Lagarde of the ECB and several other central bankers have been keen to reaffirm over the past couple of weeks as they look to calm market nerves.

Central banks also continue to have a number of policy tools at their disposal to help ensure that yields do not rise too far or so fast as to threaten economic recovery. Recent market moves pose a challenge to central banks, and investors will be monitoring communications closely for signs of a change of tone. Equity volatility may remain elevated, but at this stage we believe that policy makers should continue to support markets as required.

^{1 Source: Goldman Sachs, nominal yield data from 1965 to 2021.}