The major movements in markets over February originated from ructions in government bonds. Having been relatively benign from mid-2020, government bonds faced persistent selling across February. With the prospect of another exceptional level of stimulus from the US and successful vaccination programmes across key markets, investors are increasing of the view that longer-term yields need to be higher, ultimately followed by interest rate. Government bond yields, which are used as a major reference point and that basis for many valuation calculations, have significant implications for wider financial markets. Resultingly, equities saw some selling towards the end of the month.
The cause of rising bond yields since the COVID selloff in 2020 was twofold. Firstly, was the decreasing likelihood of further central bank interest rate cuts in the near term and the corresponding increase in the probability of rises in the next several years. While central banks have not changed their guidance, the prospect of more robust economic growth has led investors to believe that rate rises may be necessary to contain an overheating economy. Secondly, is the increase in “inflation compensation”. This is the additional return that investors are looking for to offset expected inflation. Although from a low base, inflation expectations in major developed markets have been moving higher as a stronger than expected economy combined with rising commodity prices and supply chain disruptions feed into prices.
The bond market is now approaching a point where central banks may once again intervene to reassert their policy goals. While there may be powerful selling forces currently, investors may soon remember the phrase “don’t fight the fed”. While central banks may be willing to let the market express their view to an extent, once they believe that yields have, or may rise, to a point where there will be a real economic fallout, they are likely to take action. Members of the ECB are already raising higher bond yields as an issue, potentially flagging intervention.
The most important impact of rising yields and the implication of higher economic growth on the equity market has been at a sector level, rather than index level movements. Many of the companies that have thrived during the pandemic, namely technology companies, have suggested as investors discounted their higher growth in favor of cheap “value” stocks that have more to gain from a strong economy and are likely to give higher returns to share in the more immediate future.
Investors may be having a flashback to the taper tantrum; however, the key difference now is that the selling has not been caused by the Federal Reserve attempting to move the market, rather than the market trying to anticipate the Fed. Caution may therefore be needed, as the current move may not be allowed to continue unchecked.