By Jan Faure
Spike in bond yields tests equity markets’ nerve.
February was a tail of two halves, with a solid run in equity markets being eroded at month-end by a surge in bond yields. US benchmark yields, represented by the 10-year Treasury note and30-year long bond, have increased by around 50 basis points (0.50%) this year. This has had a negative impact for bond investors as prices move inversely with bond yields.
Higher bond yields also negatively impact equity markets due to interest rates being a key input in equity valuation assumptions. As expected, the high-valuation tech stocks were the most affected by the increase in bond yields. The tech-heavy Nasdaq Composite Index declined by 5% in the final week of February. The value end of the market, especially energy and financials, were the outperformers for the month.
The energy sector rose by over 20% in February, helping the S&P 500 Index make positive gains for the month (+2.6%).This was driven by oil prices which soared by over 18% in February. The big freeze in the US state of Texas was a major catalyst with more than 4 million barrels a day of crude oil output going offline. The loss of US output is a global issue as this supply needs to be replaced from elsewhere. Besides oil, commodity prices in general have rallied this year with base metals, iron ore and agricultural commodities all making solid gains.
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A further beneficiary of the move higher in bond yields was the banking sector. This helped European market indices, with traditionally high exposure to banks, make positive gains for the month. The financial sector was the second-best performing sector (after energy) across US markets in February.
The impact of rising yields on the stock market is very much the topic of conversation in markets at present. The US Federal Reserve wants real yields to remain below 0% given high levels of public and private sector leverage. Negative real yields have helped markets recover from last year’s Covid market collapse but low interest rates, coupled with aggressive stimulus measures, does risk inflation.
It is noteworthy that President Joe Biden’s $1.9 trillion (additional) Covid relief package passed through the House of Representatives (and now moves on to the Senate). Stimulus measures have certainly helped the economic recovery but excessive liquidity, if coupled with a return of consumer confidence as vaccines are rolled out, can cause the economy to overheat.
Markets are not yet ready for the prospect of rate hikes and central banks will need to carefully manage this. Fed chairman Jerome Powell has continuously stressed policy support and his recent message to markets was that higher bond yields reflected economic optimism, not inflation fears.
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