The sell-off in global bonds over the last month has raised concerns that the recovery in US equity ...
The sell-off in global bonds over the last month has raised concerns that the recovery in US equity markets could be derailed.
Since bottoming on 13 June this year, 10-year US treasury yields have increased 130 basis points after the Fed cut rates by 25 basis points rather than the 50 anticipated by the market. European government yields also saw a 60 basis point lift over the same period.
Jim O'Neill, an analyst at Goldman Sachs, noted the sell-off was partly a reaction to the 100 basis point drop in Treasury yields between early-May and mid-June, triggered by the Fed hinting short rates will stay low for a long time.
The rise in yield counters the Fed's fiscal easing, leading to a retrenchment in the refinancing markets and a choking of corporate free cashflow as more money is allocated to debt-reduction. However, the falling dollar scenario, encouraged by the Fed's public abandonment of its strong dollar policy, boosts US exports as domestic companies' pricing becomes more competitive internationally.
Moreover, the volatility in bond yields is being exacerbated by holders of mortgage-backed securities selling into falling markets and buying rising markets to rebalance the duration of their portfolios and counter moving demand levels in the mortgage refinancing market.
The equity markets have already been hit by this yield hike, which has led to a reduction in the equity risk premia, making valuations less attractive on a relative basis, O'Neill says. He remains cautiously optimistic yields will recede as economic growth picks up and the dollar weakens further.
'The difficulty of sustaining the refinancing engine and its contribution to spending growth is one reason why we have argued US growth will probably slow towards the middle of 2004 and will find it hard to break the 3.5%-4% limit in the meantime,' O'Neill says.
'If yields settle as we expect, that risk will be avoided. If they track higher, that slowdown might come earlier.'
Peter Lucas, global strategist at Ashburton, says: 'Historically, the dollar has tended to perform best when equities have outperformed bonds and when US bonds have underperformed their international counterparts.
'It is our belief the dollar will bottom when the US economy has recovered sufficiently for the Fed to stop propping up the bond market. It is possible we have reached that point already, but the technical picture is far from conclusive.'
Past studies of similar bond yield spikes, such as those of 1994 and late 2001, leads O'Neill to favour shorter-dated US Treasuries to equities in the short- to medium-term. He said typically equity markets find it harder to gain ground following a run-up in yield than they do before and thus end up range bound. Cyclical sectors do often continue their outperformance in the early stages, but the recent March-April equity rally was already subsiding even prior to last month's bond yield spike, he adds.
'On the bond side, we have had a moderately bearish bias in our recommended portfolio since mid-June and remain positioned that way for now,' O'Neill says. 'Current yield levels on US Treasuries are becoming attractive given our views on short-term rates. It may still be a little early to enter long trades however.'
Good yields on short-dated US Treasuries.
Falling dollar to offset worst of yield spike.
Europe bond yields pulled up by US bonds.
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