Taming of the tantrum

Last Friday something important happened. The US 10 year yield traded higher and closed at a recent high of 1.625, while equities also traded higher, with US equities pushing to all-time highs after a month break.

This is especially important in the context of the volatility experienced over the past couple of weeks, whereby the skeletons of the taper tantrum in 2013 were very much at the forefront of investor’s minds. Back then, equities had sold off sharply following the announcement of the Fed that it shall increase interest rates and scale back bond purchases.

Investors were recently mindful of potential tapering of monetary policy by the Fed, despite comments to the contrary by Fed chair Powell. The concerns were enforced by the sharp expected rise in inflation following the re-opening of the US economy, as more states announced easing pandemic related measures.

Policymakers deem this to be transitory, and are content for inflation to momentarily spike. Indeed treasury secretary Yellen remarked that she prefers having an inflation problem, as the Fed has the necessary tools to put to work in order to control it. Indeed it has pledged to hold off any rate increases until realised inflation has reached 2 per cent and is on track to average 2 per cent. On the other hand, secular low inflation and economic growth is more difficult to rev up, as is the case on the European continent.

Furthermore, the Fed is explicitly committed to achieving maximum employment, which at present is a far reach. Unemployment is at highly elevated levels due to the pandemic, and it will take time until these numbers are reversed to pre-pandemic levels, with the Fed expecting at least 3 years. The bottom line is that any tapering is yet a while away and the bears are jumping the gun on this one.

The argument for increasing yields is a cause for debate, as some commentators deem it to be as a consequence of increasing inflation expectations, while on the other hand there is an argument that it has been out of line with economic fundamentals, not been supported by changes in data on growth or the rollout of the Covid-19 vaccines or other developments.

Its trajectory will undoubtedly be closely followed throughout 2021, as a yard stick for the direction in which market participants believe the recovery is going. Increasing yields should have a positive connotation, while decreasing should indicate that there is a spanner in the works.

In this context, the outlook for bonds and equities is diverging. Equities are set to perform in a low yield, growing, and inflationary environment. On the other hand bonds, particularly investment grade, are generally expected to underperform on rising general yield levels. High yield bonds are more insulated from rising yields due to their spread cushion, and pockets of value remain in beaten down sectors.