The sell-off in US Treasury bonds reversed over the last week with the 10-year bond yield dropping from its intraday high of 1.75% on 18 March. The decline was driven principally by falling real yields as inflation expectations were mostly stable. There was also a reversal in the recent outperformance of value stocks relative to growth stocks.
The change in the trend for US Treasury yields came as the US Federal Reserve (the Fed) telegraphed that it was less worried about the increase in yields since this reflected stronger economic growth (hence higher real yields) as well as higher inflation expectations (which is exactly what the Fed wants).
Expectations for an increase in US policy rates, however, were less welcome. The message here has been that the market is overeager in thinking that the federal funds (fed funds) rate will rise by as much, and as soon, as is reflected in futures markets.
This notion was emphasised by the publication of the Fed’s ‘dot plot’ showing policymaker expectations for the fed funds rate over the next two years. Only seven out of 18 central bankers forecast a rise in policy rates by 2023.
The market responded unexpectedly: instead of falling, expectations for higher rates grew (see Exhibit 1). This move perhaps reflects the market’s scepticism that the Fed can resist having to tighten policy as headline inflation surges this summer.
The reversal in US yields was mirrored by an underperformance of US value stocks relative to growth stocks (see Exhibit 2). European value stocks were slightly more resilient as they had rallied by less previously.
In contrast to the Fed, which is less concerned about the rise in US market interest rates, the European Central Bank has stepped up its bond purchases to prevent eurozone yields from rising too far.
The key dynamic for equity markets continues to be the rotation from growth into value, rather than from defensives into cyclicals, or even from large capitalization stocks into small cap. Since 15 February, when the latest surge in US Treasury yields began, growth indices have underperformed value indices significantly, while the gap for other pairs has been narrower.
European equities have managed to outpace US equities despite the widening divergence in growth expectations between the two regions. The outperformance was not due to better returns for European value stocks; as we noted above, European value has lagged US value. Rather, it was the resilience of European growth stocks. This segment is less exposed to the interest-rate sensitive technology sector (see Exhibit 3).
Economic data has generally come in better than expected recently, particularly the flash purchasing manager indices for March. Purchasing Manager Indices (PMIs) for manufacturing have been strong for several months now as the lockdowns have not kept consumers from buying goods via the internet – goods that need to be manufactured. With the exception of the US, however, service sector PMIs had been in contraction territory.
The flash data shows the UK economy moving back into positive territory, though the eurozone still lags (see Exhibit 4). In the near term, this indicator is likely to remain weak for the eurozone as many countries are increasing restrictions in the face of a third COVID infection wave. The medium-term outlook is still bright, however. The rollout of vaccines should eventually allow countries to exit the lockdowns.
One key data surprise was US retail sales (ex-autos and petrol). At -3.3% against the prior month, it fell short of expectations of a decline of just 0.5%. This is at least partly explained by the upward revision to sales growth in the previous month from 6.1% to 8.5%, leaving the two-month moving average just 0.2% lower.
Another explanation for the more subdued spending is the recent arrival of government stimulus cheques which are being saved rather than spent. Apparently, at least some of the money has been going into equities.
Flows over the last few weeks have been positive to most regions, though to some degree, this just reverses the outflows seen at the beginning of the year (see Exhibit 5). Flows for the latest week were notable in that it was the first week in nearly a year where equity funds saw inflows while bond funds had outflows.
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.
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