A key trading theme on Monday has been renewed rise in market risk-free interest rates in the US. The yield on 10-year Treasury bond after short consolidation near 1.30% mark last week has updated its local high Monday, rising to 1.38%. This led to increased anxiety in equities: US stock index futures tumbled, SPX by about half a percent, Nasdaq by more than 1%.
There are two key channels through which an excessive rally of Treasury yields exerts pressure on equity markets:
- Bonds vs. stocks choice. Some investors start to rebalance their portfolios, dumping stocks and buying bonds as they became cheaper and start to offer meaningful returns. Stocks which have high duration (like growth stocks) are good candidates for replacement by bonds and tend now to sustain more losses;
- Borrowing costs channel. The effect of the rise in risk-free rates feeds into other credit market rates, so it’s reasonable to expect that long-term borrowing costs for firms will rise as well. This has negative effect on shares value as rising interest rates reduce firms’ access to cheap financing.
Nominal interest rates in the US are rising due to expectations of new fiscal stimulus, which in turn will lead to an increase in the supply of Treasuries in the market. Spurred by government spending economic growth should lead to higher inflation, so investors are now also demanding higher compensation for this risk. Comparing yields on 10Yr Treasury Note and bonds with same maturity but protected from inflation (TIPS) we can clearly see the steep rise in inflation premia:
This week, attention will be focused on Powell testimonial in the US Congress. Also, the Fed will release a semi-annual report on monetary policy. Investors will examine the report for clues on the essence of the Fed’s new concept of inflation targeting. It’s still not clear from the Fed communication what should be trajectory or rate of growth of inflation which can enable the Fed to lift interest rates. We are talking about a change in rates on a more distant horizon, but long-term investment assets should be sensitive to the new information, which will constitute a market reaction.
US dollar is expected to continue to drift lower thanks to benign environment for risk-on trading supported by strong US economic data. We saw huge jump in US retail sales in January but still White House administration determined to push new 1.9 tn. stimulus to the Congress. Rising self-sustained economic momentum supported by massive government spending spree in the US should trigger stronger hunt for the yield and inflation fears which is generally negative for US currency.
The technical picture also favors USD slide as we get closer to March:
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