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Posted by Greg Taylor on Mar 3rd, 2021

Old Fears are New Again as Yields March Higher

February may go down as the month that bond yields reached the level where they become a problem for the equity markets. Since the post-pandemic sell-off, the rally in equities has been accompanied by a move higher in yields. The US 10-year Treasury yield, which touched 0.5% last summer and finished 2020 at 0.9%, ended February above 1.4%.

The dramatic increase in government spending, accompanied by an extremely accommodative central bank and positive virus news, has made investors ever surer the economy is ready to emerge from the global lockdown on fire. Yields were moving up for all the right reasons, which was a positive for equities. But have yields now moved too far, too fast?

Central bankers have been signaling that they are willing to let the economy “run hot” and risk inflation, but the market may be calling their bluff. If the market is telling central banks to make a move before inflation ticks meaningfully higher, that could pose a problem.

As we all know, the most powerful force in capital markets is the central banker. One of the lasting impressions from the pandemic is how quickly they acted to stabilize markets. But we also know at some point they will have to take the foot off the gas and scale back the emergency programs.

The fear is that the market won’t be ready for this and we could see a repeat or something similar to the 2013 taper tantrum, in which the Federal Reserve signaled it would slow down quantitative easing programs. The original taper tantrum caused a quick and dramatic sell-off in equities. Some are worried for a repeat – a taper tantum 2.0.

Recent quotes from the Fed signal that members aren’t even thinking about thinking of starting the taper. But as economic news continues to improve, that will be harder for them to ignore. Good news could soon be bad for markets? Over the month, the fear emerged that they may have to pull forward that thinking into the second half of this year.  As markets are forward looking, that fear hit the markets the last week in February.

While broad markets may not suffer a dramatic sell-off on this change of sentiment, it could heighten the factor rotation that began in November. Sectors that had been leading could quickly underperform while laggards take over. While overall rates remain incredibly low, in relative terms there have been big moves between asset classes.  Most notably, as the month ended, the yield of the S&P 500 dropped below that of the US 10-year bond for the first time in over a year.

With yields moving higher, multiples tend to contract. As a result, long-duration assets will suffer and shorter-duration assets will lead. Last year, as bond yields collapsed, one of the best-performing assets was the long bond. The US ETF that tracks this (TLT) was up 18% for 2020. But in the two months of 2021, it is lower by 9%, showing the reversal of fortunes. Other long-duration assets are following, like speculative technology stocks.

By the numbers as at February 2021

Contrary to this, the best-performing asset classes year to date have been emerging markets, small-cap equities and commodities. Calls for the next commodity super cycle are everywhere. The prospect of a new multi-trillion-dollar infrastructure bill in the US would only increase the odds of this happening.  After ignoring cyclicals for years, the time for their outperformance may be upon us.

It will all come down to rates, though. The move in the bond market may begin to peak and stabilize at these levels. But it could even pullback, as well. In the short term, it does seem like equity markets need of a moment to catch their breath and this could be the trigger.

What to add on a potential dip will be key and the bond market will give us the signal of what will likely work.  A continuation of higher yields could create a situation in which both bonds and equites fall. But not all sectors are created equal and sector positioning will be extremely important for outperformance.

The market has produced dramatic returns since the lows of last March. Speculative activity has returned to a level not seen in years. There are many making the call of a bubble in markets, but we aren’t in that camp at this time.

The amount of money in the system is at an all-time high and is pushing asset prices higher. At the moment, central bankers aren’t concerned at all. Real assets have benefited from this trend and look to continue higher. But volatility is here to stay for a while and active strategies will be key for adding value in a rapidly changing world.

— Greg Taylor, CFA is the Chief Investment Officer of Purpose Investments

All data sourced from Bloomberg unless otherwise noted.

By the numbers displays total returns for the month of January, 2021. The content of this document is for informational purposes only, and is not being provided in the context of an offering of any securities described herein, nor is it a recommendation or solicitation to buy, hold or sell any security. The information is not investment advice, nor is it tailored to the needs or circumstances of any investor. Information contained in this document is not, and under no circumstances is it to be construed as, an offering memorandum, prospectus, advertisement or public offering of securities. No securities commission or similar regulatory authority has reviewed this document and any representation to the contrary is an offence. Information contained in this document is believed to be accurate and reliable, however, we cannot guarantee that it is complete or current at all times. The information provided is subject to change without notice.

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Greg Taylor, CFA

Greg Taylor is the Chief Investment Officer of Purpose Investments. A data-driven manager with a focus on managing risk through active-trading strategies, Greg specializes in finding and exploiting pockets of volatility in the market to drive returns. He spent more than 15 years managing pension and mutual fund assets at Aurion Capital Management. He also held a role of senior portfolio manager at Front Street Capital and LOGiQ Asset Management before coming to Purpose Investments.