Another game of two halves – risk assets yield to rising long term interest rates
When we composed the February mid-month update on the 15th, ten-year gilt yields were 0.52% and ten-year US Treasury yields were 1.21%. Fast forward to month-end and yields on those bonds were 0.82% and 1.41% respectively, with the US ten-year having traded above 1.6% intraday on the final days of February.
The speed of the moves upwards in yields, rather than their finishing levels, unnerved financial markets and investor sentiment which had previously been buoyant – probably overly so.
As in previous months, February 2021 was a game of two halves. Like January, a month where ‘game’ took on a new meaning through the price action of GameStop and other ‘penny’ stocks amidst the gamification of the stock market, the first half of February was in sharp contrast to the second half with the mid-point of the month acting as the tipping point for risk assets.
As US short rates (as reflected by the two-year yield) remained relatively anchored at just over 0.10%, the US government bond yield curve steepened. As this is usually a situation that helps financial institutions who borrow short and lend longer, there was a significant disparity in the performance of key indices during February, particularly from the middle of the month.
As the following graph from Financial Express illustrates, the S&P 500 Financials index was up almost 10%, whereas the tech-heavy Nasdaq composite index was in negative territory.
Of course, one month has merely made a small dent in the outperformance of the Nasdaq over the S&P 500 Financials index – so does this represent a changing of the guard?
As we noted in our recent blog, ‘Inflation’, financial markets are concerned that an easy monetary policy and stimulated consumers plus vaccine rollouts, equals higher inflation.
The US Federal Reserve has been clear in its recent statements that it is comfortable as the upcoming spike in inflation is a result of low inflation levels a year ago post the pandemic outbreak and first lockdown. Consequently, the year-on-year inflation numbers in the US, UK and most developed economies should prove temporary. To compensate for a lengthy period of below target (2%) inflation, central banks are sanguine about inflation running above target for a period of time. They see the real challenge as lowering unemployment.
Nevertheless, it was the economy re-opening sectors that did well in February as did small cap stocks. Many of February’s winners have been strugglers for the past year so may be entitled to have some time in the late February sunshine. The so-called ‘value, reflation’ trade may have more legs but value traps lurk. As thematic investors with a bias to smaller growth companies we understand that the areas we favour may have got ahead of themselves, but we view the second half of February was a recognition of overbought retrenchment rather than a secular change of fortunes.
Sterling was surprisingly strong in February, perhaps buoyed by UK assets gaining more favour internationally, attracting capital inflows, plus a recognition of an impressive vaccine rollout leading to an irreversible economic re-opening.
Conflict of (Real) Interest
The weakest seven-year US Treasury auction, as measured by the bid-to-cover ratio (weakest demand), was one of the catalysts for the raised government bond yield volatility in the final week of February.
While we have referenced the US and UK, the rise in Australasian government bond yields was even more dramatic. Although central banks can step in and buy their own government’s debt to smooth the rise in yields, they seem happy to maintain negative real yields (bond yields below inflation) which helps to inflate away the increasing levels of debt being issued to fund corporate and individual financial support.
Trying to let the air out of the balloon slowly in a bond market still priced for borrowers is a difficult act, but within central banks remits.
Corporate bond spreads, already at historically low spreads to government bonds, mirrored the oscillations of those yardsticks.
All that glitters…
Well, it wasn’t gold in February. February’s scenario should have been a positive for gold, but it didn’t seem to matter as the yellow metal fell 6.5% over the month.
Cryptocurrencies did well but remained extremely volatile with the validity of Bitcoin challenged by monetary authorities and the likes of Elon Musk.
The winners in metals and mining without excessive volatility were the industrial kind such as copper, benefiting from strong demand.