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Rising treasury yields flash a warning sign

(Bloomberg Opinion) – US Treasury bond yields saw some notable movements in the early days of 2021. If they continue at their current pace, their underlying drivers risk headaches for both policymakers and stock investors alike. Bear steepness “is called. The 10- and 30-year bond yields rose 20 basis points and 22 basis points, respectively, over the period. The spreads between these maturities and the two-year Treasury bill, on which Federal Reserve policy has a significant influence, have widened significantly – from 80 basis points to 98 basis points for the 10 years and from 152 basis points to 174 basis points for these steps come when Fed policy has continuously sought to suppress yields significantly and keep them in a tight trading band. Should the moves continue, they would also challenge some of the strong drivers of equity and other risk-weighted funds, by reducing their relative attractiveness and weakening the buy signals emitted by models that involve discounting future cash flows. Furthermore, their persistence would hurt the economic outlook due to their underlying drivers and the potential impact on interest rate sensitive sectors such as housing. What are these drivers? Recent movements in the US yield curve do not reflect any actual or forward-looking change in the Fed’s highly accommodative stance on monetary policy. In the minutes of the December Federal Open Market Committee meeting released last week, it was reiterated that the central bank has no intention of reducing its incentives anytime soon, and if it does, the process will be extremely gradual run away. Some of the other potential contributors are also unlikely to play a role, such as increased government default risk or more favorable growth prospects. If anything, the Fed’s willingness to expand its balance sheet indefinitely reinforces the notion that there is a steady and reliable non-commercial buyer of government bonds. Meanwhile, growth prospects have deteriorated in the shadow of the recent surge in infections, hospital stays and deaths related to Covid-19. A loss of 140,000 jobs in December was reported in Friday’s monthly US job report. The Democratic expansion of the two Georgia Senate runoff elections last week has raised the prospect of higher government budget deficits and much greater leverage. However, since the Fed is not only committed to maintaining its large asset purchases, but is also open to increasing it and shifting more purchases into longer-term stocks, such a prospect shouldn’t have an immediate significant impact on returns. The Most Likely Drivers So there are expectations for higher inflation and more hesitation from government bond buyers. The former is supported by movements in the inflation interruptions and other inflation-sensitive market segments. The latter is in line with the significant market talk about how government bonds, which are so heavily suppressed by the Fed and have asymmetrical prospects for yield movements, are no longer ideal for risk mitigation. An intensification of recent movements in yield curves in the weeks ahead would be important to both policy makers and risk takers in the markets. While the Fed is hoping for higher inflation, it does not want this to be achieved through “stagflation” – that is, even more disappointing growth and higher inflation. The Fed has few, if any, tools to pull the economy out of such an operating environment. This, as well as the negative impact on corporate profits from the lack of economic growth, would exacerbate the already extremely large separation between financial valuations and fundamentals. The most dominant and almost universal market view at the moment is stocks and other risk assets will continue to rise due to the abundant injections of liquidity from central banks and the allocation of more private funds. After all, central banks do not tend to tone down their enormous incentive. And investors are still heavily dependent on a strong mix that has served them very well so far: TINA (there is no alternative to stocks) encourages BTD (Buy the Dip) behavior in response to even the smallest market sales, especially in the face of FOMO (the fear of missing the return of impressive market rallies). As valid as these considerations are at present, they also warrant close monitoring of the yield curve for US Treasuries. A significant continuation of recent trends would challenge the Fed, investors and the economy. This column does not necessarily reflect the views of the editors or Bloomberg LP and its owners. Mohamed A. El-Erian is a columnist for the Bloomberg Opinion. He is President of Queens’ College, Cambridge. Principal Economic Advisor at Allianz SE, Pimco’s parent company, where he served as CEO and Co-CIO; and Chairman of the Gramercy Fund Management. His books include “The Only Game in Town” and “When Markets Collide”. For more articles like this, visit bloomberg.com/opinionSubscribe. Visit the Most Trusted Business News Source Now. © 2021 Bloomberg LP