US 10-year Treasury yield rose to 3% shortly on 24 Apr 2018, helped by strong February house price data, a better equity market open and improvements in consumer confidence in April.
What will be the FOMC’s next move? Despite the rising US/China trade tensions, the US Federal Reserve has not yet seen enough evidence to alter its expected policy path. Investors now place a 93.2% probability on the Fed hiking interest rates at its June meeting. Over the next 12 months, the market is pricing 69.6bps of cumulative hikes, which is between two and three 25bps rate hikes.
Does the yield curve have room to flatten even further? Looking back at the flattening spreads between 2-year and 10-year Treasuries in 1988-89, 1999-2000 and in 2005-06, there is still significant room for the yield curve to flatten. If history repeats itself, the curve could flatten for an additional 10-20 weeks before reaching its lowest level and turning back.
How do other major economies react and what is expected to come? Absent strong Eurozone economic and inflation data, the European Central Bank has little room for tightening. Following Treasuries’ lead, yield curves in Europe were modestly flattening although spreads for the Italian, Portuguese and Spanish government bonds are all sitting still. Yields on the German 10-year Bund rose as high as 0.656% as the 10-year Treasury briefly broke 3%, but closed unchanged from the previous day. On the other hand, the Bank of Japan is not likely to reduce its government bond purchases in the near term even if the yield curve is facing flattening pressure.
How will a shrinking Fed balance sheet impact High Yield credit? Credit spreads tend to tighten in a rising interest rate environment, reflecting improved credit fundamentals in a growing economy. The positive return due to credit spread tightening could cancel out some of the negative return from rising rates. Based on 1994-2017 historical data, credit spreads of high yield bonds strongly correlate with 10-year Treasuries, such that a 1% change on Treasury yields will incur a roughly 0.57% change on high yield bond yields. Since we believe the yield curve will flatten, the effect of the interest rate hikes on a high yield portfolio could be even less.
Are equity markets even paying attention? US stocks declined amid earnings that did not react much to the yield jump. The STOXX Europe 600 Index fell along with US equity-index futures after less-than-optimistic earnings forecasts. The rate hike in the US reflects real economic growth, margin expansion and asset appreciation, so we expect the stock market to perform positively as long as the rate hikes follow a gradual path. However, once rates reach 4%, it then becomes a headwind for growth and a financial burden for corporations.
Making the US Dollar great again? The US dollar resumed its advance to head for a 3-month high against other majors, including the Yen and Euro as 10-year Treasuries reached 3% for the first time in four years. Yet with US net international asset positions sharply deteriorating and the largest twin deficits in recent history, this spike is more like a fiscal boost that is not likely to last.
Last but not least, what about the trade war? Recent Trump administration policies have stoked trade tensions, and more damaging policies may still in the pipeline. The US may impose sector-specific trade restrictions in coming months, particularly with a view toward rebalancing trade with China, without engaging in a full-scale trade war. The OECD estimates that a permanent 10% rise in trade costs would lower global GDP 1-1.5%. If an outright trade war were to materialize, global equities could sell off and US interest rates could fall.
Coming up next… Yields on 10-year Treasuries will continue gradually rising and the yield curve is expected to flatten further. Credit spreads will also widen slightly as the secondary market reprices. Meanwhile, supply is expected to remain heavy in the near term as issuers line up to enter the market. The prospect of continued double-digit earnings growth for Chinese, US, European and Japanese firms and a US GDP growth that has outperformed since the financial crisis, we remain broadly positive, with some caution toward long-duration assets.
Where might be a good opportunity to invest? Increased volatility during the current market correction, higher trading volumes and higher interest rate are positive catalysts for improved earnings in the financial sector. We are also positive on the recovery in the capex cycle, particularly in the industrial, electrical, digital and healthcare sectors.
