In recent weeks, we’ve seen a sharp pullback in U.S. bond prices and a corresponding increase in yields. At the beginning of 2021, the 30-year treasury bond was yielding 1.66% as compared to a March 15 yield of 2.38%. As far as bond market moves go, that is a substantial change over a short period of time. It is a particularly interesting move given that the Federal Reserve Bank hasn’t made any rate changes and hasn’t alluded to any rate changes. Why might the bond market be moving?
Price movement in the bond market is generally a result of either (a) a change in perceived risk, (b) a prediction about the direction of benchmark rates set by the Federal Reserve Bank or (c) a prediction about what is happening related to the overall economy. So, which future is the bond market foretelling?
It’s unlikely that this move has anything to do with risk (i.e., that bond investors are requiring a higher yield because of higher risk). The reason that hypothesis seems unlikely is that equity market risk-taking is off the charts. Sentiment indicators are showing that investors are in risk-taking mode and the recent success of various IPOs and other tech companies without earnings supports this thesis. It is somewhat more plausible that the market is now expecting a potential increase in rates by the Federal Reserve Bank, but even that thesis is flawed. For one, the Federal Reserve Bank has explicitly stated that they’re “not even thinking about thinking about raising rates,” and history indicates that central banks are extremely slow to raise rates coming out of a recession. Given that we’re only partly through a vaccination rollout and just starting the economic recovery process, it’s safe to say that rates aren’t likely to move anytime soon. So, it seems that the most likely cause of the bond market reaction is a prediction of an economy that is picking up steam and that may lead to an increase in capital demands and potentially inflation.
Bond market yields generally start rising ahead of an economic acceleration because an improving economy eventually pushes yields higher. Good economic conditions increase the demand for capital and, in some respects, rates reflect the demand for money. An improving economy also tends to accelerate the demand for goods and services, which can cause an increase in inflation. Any increase in inflation is generally going to be reflected in bond yields given that investors will require bond yields to exceed inflation rates so that “real yields” (i.e., yields minus inflation) remain positive.
How might portfolios be adjusted given the rise in yields? Rising yields are most punishing to growth equities. The reason for this is that growth companies have earnings that are pushed furthest into the future and any increase in the discount rate for those earnings lowers a given company’s present value. We’ve seen this play out in recent weeks as the high growth technology sector has fallen while yields have risen. In this type of environment, value and high dividend stocks tend to come back into favor. Moreover, industries that are heavily impacted by economic cycles can see improvement (e.g., basic materials, manufacturing, banking and energy).
Inflation, if it materializes, will likely be very positive for commodity investments and precious metals. We’ve certainly seen a move higher in commodities but precious metals have actually fallen during this period. It’s important to note that precious metals are more impacted by “real yields” than the general level of inflation. Given that bond yields have risen so aggressively, real yields have remained positive and have adversely impacted precious metals. If yields stabilize with a continued rise in inflation, precious metals are likely to perform well.