Low sovereign bond yields, at this stage in the economic cycle, are bad. If they continue to fall, it will represent a negative outcome for the economy. Importantly, lower rates in the near-term could constrain the equity bull market. We expect yields will begin to move higher. That will support strong equity market returns. But investors should be aware of the risks to that view.
US and Australian 10-year yields have been falling since late-February (Chart 1).
Chart 1: Longer-dated sovereign yields have been declining since February.
This move lower has been accompanied by rising inflation (Chart 2).
Chart 2: Inflation is moving higher in the US and Australia.
Equities have so far taken the lower yields in their stride (Chart 3). Aside from China, most major equity markets have pushed to fresh cyclical peaks. Lower yields have slowed and, in some cases, reversed the rotation from growth stocks in to more cyclical and value stocks.
Chart 3: Global equities have continued to push higher.
We think lower yields are a major risk to the equity market rally. Nominal yields should be moving higher at this stage of the economic recovery.
That should be led by real (inflation-adjusted) yields. Higher real and nominal yields would reflect a confidence that the economy is recovering. It would reflect capital being allocated from the safest assets to investment in riskier opportunities.
We expect equity markets will deliver solid returns over the medium-term. Lower rates supported equity markets in the very early stages of the pandemic recovery. But now lower rates are simply signalling growth and inflation outlook concerns.
And cross asset movements are showing that. Risk-off and safe haven assets – including the Japanese Yen, the US dollar, US Treasuries and Australian Government bonds – are all performing well.
Risk-on assets – including the Australian dollar – are struggling to deliver further gains.
The coming months will be critical for the US Federal Reserve, the Reserve Bank of Australia, and other central banks to manage expectations for a strong recovery, a reduction in quantitative easing, and a gradual move higher in yields.
Equities will continue to deliver strong returns if that is managed well.
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