Mind The Gap
US 10-year Treasury yields gapped higher in early October. The yield has now reached 3.18%, the highest level since 2011. A higher yield can have meaningful impacts on other asset classes. It can also impact the economy. We continue to believe that the US is headed for recession in 2020. What does the gap higher in yields tell us? And what should we be keeping an eye out for?
Figure 1: US 10-year yields have reached the highest level since 2011
What has happened to US Treasuries?
The 10-year yield increased more than the 2-year yield. This widened the spread between the two yields to 31bps, the widest since July this year (Figure 2).
Figure 2: The spread between 10-year and 2-year US Treasury yields has widened
Why has it happened?
What drove yields higher? It is always difficult to assign reasons to single events. But we expect yields have moved higher and will move higher still for at least three reasons:
- Solid economic data in the US – in particular labour market data and services sector data (green indicate the latest data have improved, red that it is weaker)
Table: Economic data have been solid in the US
- A growing realization in the market that the Fed will deliver more rate hikes over the coming 18 months.
- A shift in market positioning. The initial gap higher suggests a capitulation in positioning for technical reasons. That could continue as bearish sentiment on bonds pushes yields even higher.
What will higher yields mean?
Higher bond yields have implications for equities and fixed income returns.
Higher bond yields increase the rate at which equity cash flows are discounted back to fair value. Directly, this can put downwards pressure on equity prices. But US equity prices have continued to rally (Figure 3).
Figure 3: The S&P500 has reached record highs
I expect that solid economic growth and late-cycle dynamics (including elevated merger and acquisition activity and share buybacks) will continue to support US equity returns over the near term. Over the medium term, we remain concerned about a likely recession in 2020.
For fixed income, higher bond yields do not necessarily mean negative returns. However, it is can be important to reduce exposure to longer-duration bonds that have prices which are more sensitive to interest rate changes. It is also important to move up the credit spectrum to higher quality credits. Lower quality credits face greater default risk as the cost of servicing debt increases.
What have we done?
We moved our portfolios to be positioned for higher US Treasury rates and rising US equities in early June. We expect these portfolios will continue to perform in the current environment.
If you are interested in discussing how we can help adjust your portfolio to deal with the global outlook please get in touch with your advisor or with Oreana Private Wealth here.