Last week’s technical break higher in US 10-year bond yields has understandably led to concerns that rates could head much higher and potentially undermine equity valuations. Against this background, this note assesses the outlook for both US bond yields and the equity market.
Going Up: US 10-year Yields break the 3% barrier
After trading largely sideways over 2017, US 10-year bond yields have resumed their uptrend so far this year and only recently broke through the psychologically important 3% barrier.
As seen in the chart below from Bloomberg, US 10-year yields have not consistently been above 3% since early 2011 – seven years ago. In fact, US 10-year bond yields have now more than doubled from their 1.35% low in July 2016. This begs the question: what’s causing the rise in yields, and will they lift much further? Even more critically, what impact will rising yields have on the equity market?
Re-normalisation of inflation expectations
Part of the rise in bond yields reflects a return to more normal inflation expectations. As seen in the chart below, over recent years the bond market’s implied break-even inflation rate* has averaged less than 2% – and often getting as low as 1.5% – compared to a relatively stable long-term average (since 2003) inflation expectation of 2%.
At around 2.2%, the market’s break-even inflation expectation has now largely normalised – in fact it’s now a little above its long-run average. Barring a major break-out in US inflation (which is still being debated by the market, but unlikely in my view), there should not be much more upward contribution to bond yields from inflation expectations.
Real bond yield should rise, but average less than in the past
That leaves the real 10-year bond yield (i.e. the rate on inflation-indexed bonds) which has also lifted – from near-zero rates in recent years to just under 1%. In turn, this has reflected progressive Fed policy tightening, through both increasing short-term interest rates and gradually unwinding its quantitative easing (“bond buying”) program.
Real 10-year bond yields are still somewhat less than that averaged prior to the global financial crisis (between 2003 and 2007 they averaged around 2%), but it seems unlikely they’ll average anywhere near 2% over the foreseeable future. My base case is that real yields won’t push much past 1% over the next 12 months.
Why? Notwithstanding the Fed’s ongoing balance sheet rundown, the main reason real bond yields are likely to be contained is because the Fed’s policy tightening cycle is maturing. As I’ve previously argued, the Fed’s implied real neutral Fed funds rate is now around 1%, down from around 2.2% as recently as 2012. Given the Fed has already raised the real Fed funds rate from negative 2% to almost zero, it is arguably almost two thirds of the way toward restoring the funds rate to neutrality. As the Fed’s policy tightening cycle matures, it should have a diminishing impact on longer-term interest rates – as is already evident from a flattening in the yield curve.
All up, my base case view remains that the Fed will only raises rates twice more this year (in June and again in either September or December), and that US 10-year bond yields will end the year around 3.25%.
Equities should withstand a further modest gain in bond yields
History shows that higher bond yields tend to have a negative impact on equity valuations. Assuming the rise in bond yields is modest, however, the impact on equity valuations should also be reasonably modest. What’s more, the impact on equity prices may well be more than offset by continued solid growth in US corporate earnings. All up, my projections suggest the S&P 500 could still end the year at around 2800 – only modestly higher than current levels, but still enough to avoid global equities more broadly descending into a bear market.
*Break-even inflation is the yield difference between nominal and inflation-indexed bonds. This yield gap reflects both inflation expectations less a small premium (i.e. lower yield) for nominal bonds owing to their better market liquidity, especially in time of financial stress.