What next as US Treasury yields hit new high?

The 2018 selloff in US government bonds led to the yield on a 10-year note rising to a new seven-year high of 3.25% on Tuesday, increasing increased anxiety among stock market investors.

Yields on US government bonds, known as Treasuries, have been rising sharply on the strong performance of the country's economy and the central bank's "quantitative tightening" after years of looser policy. Reduced liquidity and higher cash interest rates are headwinds for shares.

But some investors have switched from worrying about the US economy cooling to concerns that it could run too hot.

Yields are rising in such as way that the yield curve, which is the difference between the yield on 2-year and 10-year Treasuries, is now steepening as 10-year yields rise faster than 2-year ones, even though the 2-year are their highest yields since 2008.

Concerns about the growing trade war are not derailing the Federal Reserve’s pursuit of gradually lifting short-term rates.

Pointing to the “remarkably positive set of economic circumstances” revealed in US data last week, Powell said: “Interest rates are still accommodative, but we’re gradually moving to a place where they’ll be neutral. We may go past neutral. But we’re a long way from neutral at this point, probably.”

The market, based on Fed Fund futures, is pretty much pricing three hikes before the end of 2019.

'GOLDILOCKS' CONDITIONS FOR USA?

“One huge part of the bull case for the US stock market is that the American economy is in a ‘Goldilocks’ phase: not so cold that it threatens to slow healthy corporate profits growth but not so hot that it forces the US Federal Reserve into raising interest rates more quickly than expected,” said Russ Mould, investment director at AJ Bell.

The steepening yield curve is testing this argument, Mould said. An inversion of the yield curve is traditionally the precursor to a recession.

“The sudden spike in Treasury yields and steeper yield curve may deal with prior worries over an inverted yield curve, where the 2-year yield exceeds the 10-year, a development which is often seen as a warning of imminent recession - even if the 0.34% yield premium on 10-year paper relative to 2-year is still very skinny," he said.

Although previously ‘Goldilocks’ theories mooted in 2000 and 2007 eventually came unstuck, Mould noted that the steeper curve "does not guarantee that the long-awaited stock market correction is upon us, but it does raise the risk of an accident".

Some investors may have switched from worrying about the US economy cooling to concerns that it could run too hot, highlighting the delicate balancing act for the Federal Reserve's Federal Open Markets Committee, although Fed chair Jerome Powell has made it clear on several occasions that the primary concern of the FOMC is meeting the central banks twin mandates of inflation and employment, not helping people make or avoid losing money in the markets.

STOCK MARKET IMPACT

Mould said the US third-quarter reporting season beginning at the end of this week is "all the more important" as a strong round of results with plenty of upgrades for the fourth quarter could soothe some nerves, "but any stumbles and disappointments could leave investors more confused".

Rising rates are a double whammy for stocks, noted Neil Wilson, chief market analyst at Markets.com, leading to higher corporate debt costs, a lower premium to hold riskier assets against safe haven Treasuries.

The aggregate corporate interest bill in the USA may rise in 2018, a note from Goldman Sachs recently stated, after many years where higher debt has been more than offset by lower rates and bond yields.

"The question is do rates rise further from here?" wondered Wilson. "A confluence of factors mean US yields could continue to climb with the Fed tightening for longer, its balance sheet being reduced and a huge issuance of debt to fund the tax cuts in the US."

If anything, he said, the US economy in fact just looks stronger and stronger, and the yield story "is not a reflection of fears of it being a bubble, but of greater confidence in growth".

IT'S REPORTIN' SEASON

Friday kicks off the reporting season with numbers from the megabanks Citi, JPMorgan Chase and Wells Fargo.

Head into another quarter of 20%-plus earnings growth for US corporates, said Wilson, "we might expect further steepening in the curve from here".

While Fed policy and US Treasury issuance are both draining liquidity from markets, corporations have also reduced liquidity last week as stock buybacks declined and dividend payments slowed, UBS equity strategists noted this week that buybacks are likely to increase in the coming quarter.

More than a threefold increase in buybacks and dividends are due over the next six weeks, UBS has calculated, rising from the current circa-$14bn weekly pace to around $48bn by mid-November. Buyback announcements during the third quarter rose more than twofold on last year, "suggesting potential upside" to the pace seen in the first half of the year.

COMPLACENT MARKETS?

“The bond market is suffering from the boy who cried wolf,” Chris Iggo, chief investment officer for fixed income at Axa Investment Managers, told the Financial Times. “The market was complacent about Treasuries and seems to have underestimated just how strong the economy is.”

Andrea Iannelli, investment director at Fidelity International, added that the effect from the Trump administration’s tax cut will fade next year, and pointed out that rising Treasury yields and the dollar are already causing some stresses in the financial system.

“The bears in the US Treasuries market have so far been vindicated, but there will be eventually an inflection point where higher yields will weigh on risky assets,” he said. “Markets should not get too complacent.”

Rising inflation can cause bonds to sell off - raising yields - but not so with this latest move.

Holly MacDonald, chief investment strategist at Bessemer Trust, said that unless inflation picks up materially, it's hard to see a real bond bear market.

She noted that the fact that Fed chief Powell has repeatedly been on the hawkish side "means that people are now realising that he is serious about tightening monetary policy”.

US breakeven breakeven rates, which gauge investor inflation expectations by comparing the yields of normal and inflation-protected Treasuries, have barely moved through the course of the selloff.

If the market were of the view that the inflation pressure that we are seeing was of a more sustainable variety, said Richard McGuire of Rabobank, then he would expect the breakeven curve to be steepening.

As demand-pull inflation looks likely to remain absent, McGuire said, meaning that the real value of longer-dated Treasuries "is unlikely to be subject to a sustained challenge and the often repeated call for an end to the long-run bull market for bonds will, once again, be premature".

He added: "With the Fed looking comfortable on its gradualistic rate path but the outlook for US, and certainly global, growth best by rising downside risks, we are not willing to abandon the curve flattening theme despite the challenges this outlook has clearly experienced of late. "

Faster inflation growth raises the risk of “policy error” by the Fed, by either raising too slowly or too quickly.

It’s not easy to work out the 'normal' or 'neutral' Fed Funds rate, said Mould, pointing to the old Rudi Dornbusch saying: “None of the post-war economic expansions died of old age; every one was murdered by the US Federal Reserve.”

He added: "In the end higher rates will slow the economy. Especially this one where debt is higher now than it was in 2007. It’s just a matter of where the trigger point is."