Yields on longer dates US debt have now largely wiped out their post March 2020 collapse. The sell-off in global government debt is yet one more symptom of the so-called reflation trade and the market’s bet on normality returning over the coming months and quarters. On the one hand, with a huge fiscal stimulus plan progressing in the United States and 2021 growth recently forecasted by Morgan Stanley at 6.5% perhaps this move is sustainable. However, with much of the planet still in varying degrees of lockdown, promising yet adolescent vaccination programmes unfolding, this move and stretched price valuations could lead us to at least one more Covid-related market sell-off.
So far this week data hard and soft from all corners of the globe have fuelled and sustained the sell-off in treasuries. For the first time since the pandemic began a US 30-year note trades with a yield above 2%. With benchmark interest rates still at record lows, the steepening of the yield curve is driven by market expectations of inflation returning and a stronger economy in the longer run. But higher yields, particularly if ushered in quickly and not at a rate easily digestible by other asset markets can cause severe bouts of volatility. Record low yields in government and corporate paper across developed economies have been a source of rising equity valuations and sustained the stock market rallies we have seen since April last year. This rally in turn has been seen as the barometer of financial stability and market calm despite economic fundamental duress. If the stock market panics about rising yields in the US treasury market and other geographies, the sell-off could create a fear that raises volatility and encourages a correction of market risk appetite.
For now, however, yields remain at palatable levels for risk assets with the real yield of much global debt still in negative territory. Any severe rout in the US treasury market would be presumably data driven and therefore we will have to wait and see the impact of 12 months of disaster government spending levels and particularly the fate and effect of Biden’s new stimulus package. So long as stimulus packages serve to plug the consumer output and private investment gap rather and crowd out and over finance the economy the result of fiscal spending should not be overly inflationary. If anything, a little bit of inflation will help governments pay down the extraordinary accumulation of debt they have been forced to amass during the pandemic.
Therefore, it’s too early for the market to panic about rising inflation and should rather enjoy the prospects of a rosier economic backdrop around the corner. Immediately for foreign exchange therefore, a better determinant of value and price movement will be continue to be the relative success of a nation’s vaccination program and how quickly they can get their economy back to full output. In the US and the UK over the medium run therefore, higher interest rates at the front end of the curve coupled with strong economic growth could see their currencies outperform.
Discussion and Analysis by Charles Porter