Rates Become The Source of Risk Again
From time to time, Treasury yields actually become the source of risk for financial markets, which happened in Q1 this year and is reoccurring now.
These periods can be quite uncomfortable, as normal correlations tend to break down, resulting in unwanted experiences for investors. The good news is that periods of heightened volatility tend to be relatively short, but they can also be quite sharp. Hence, investors need to prepare for some volatility, hopefully possessing enough liquidity to take advantage of any opportunities. We think the market is well prepared to buy the dip as plenty of cash exists on the side-lines, but we all know that investor appetite can dampen very quickly, especially when markets become uncomfortable and hard to read. We think this could be where we are heading in Q4, but we also believe this represents an opportunity to improve portfolios.
So, what is causing rates to become the primary source of risk once again, and what will bring it to an end?
One reason for amplified market angst is Treasury yields have rarely been monitored so closely by so many. The move which caused the present bout of uncertainty is a mere 20 basis point jump in the 10-year yield, from 1.3% to 1.50% in the last week. In the grand scheme of things, a 20 basis point move is not a lot; however, as a percentage of the total current yield, it certainly is, and this price move actually eradicates more than a year's return in the asset. Additionally, investors perceive the speed of this price move as unsettling and fear the possibility of similarly rapid jumps in yield. If the yield moves to 1.75% by year-end, the market would simply digest a steady increase, but if the 10-year yield hits 1.60% by the end of next week and 1.70% by the week after, then markets should expect a bumpy ride as we head into the calendar's most volatile month.
Back in Q1, investors were spooked by the rapid deployment of the vaccine, particularly in the US, which would foster bumper economic growth in the second half of the year. This time we are experiencing a slowing of growth, albeit from high levels, for many reasons. But clearly, the market expects inflation to persist for a longer period than Fed officials keep telling us. At the same time, the Fed look almost committed to begin tapering from the November meeting. In addition, while the vast majority of economists are forecasting higher yields by year-end, currently, investors are not as fully positioned for this outcome as they were by the end of Q1. So, as the short base is not fully positioned, yields should grind higher as evidence of non-transitory inflation becomes more explicit in Q4.
In summary, for the moment, at least, the inflationary story is winning over the 'slowing growth' message. For current yield pressures to abate, this important dynamic will need to reverse. Either that, or the short base builds to create buyers as in Q2, but in our opinion, the latter will not happen until yields are a bit higher.
The consequence is, that for the next couple of weeks at least, we may be in for a seasonal bumpy ride.