Everybody seems to be talking about higher rates these days and their effects on the broader market. Let’s take a step back and look at what’s actually causing the global bond rout.
Government issued debt is pretty much how countries ‘print’ money. They sell this debt to investors and use the proceeds to pay for federal programs, including the enormous amount of stimulus. Just like every other security, supply and demand factors determine where the government sells this debt.
Now, US government debt has a special place in the global debt hierarchy, as its widely considered the ‘risk-free-rate’, upon which all other investments are benchmarked against. For example, all other yields trade against US government debt. It’s arguably the world’s most important financial market.
So, as US rates move higher, all other global yields tend to keep pace…this includes stocks.
- 27% of all US household income is currently paid by the US government
- The deficit is growing at a 10% annual clip and just surpassed 100% of GDP
- Another $3 trillion+ infrastructure package in the pipeline
All of the above factors have contributed to elevated inflation expectations and the acceleration of yields over the past month, however, there is one possible explanation that is getting less press.
The largest holder of treasuries outside of the American public is Japan (banks, asset managers and life insurance companies). Their year-end is March 31st, and due to their unique accounting characteristics, they attempt to adjust asset allocations near year-end. Hence, this year, that resulted in the liquidation of stocks and treasuries, which led to the global asset debacle seen over the past four weeks. The majority of selling occurred during Tokyo hours and the rest of the world followed suit.
The Federal Reserve (FED) and their international counterparts have made it very clear that this rise in yields is a healthy reaction to the overall economic recovery, and that any inflation that might result from fiscal/monetary policy will be a transient effect (yeah, right). They have blessed the steeper curve (but, not too steep) and seem to have already adopted a Bank of Japan style ‘yield curve control’. So where do we go from here?
In general, the market continues to forecast even higher rates, which will pressure everything from stocks to mortgages to student loan rates. Economists are torn as to whether the FED’s encouragement of higher yields will backfire and de-rail the relatively sensitive recovery. However, one thing is for sure – the zero-rate environment is over, and you should position accordingly.
Most folks will feel the effects in their stock portfolio and the housing market. If yields accelerate higher, stocks look less attractive and should sell-off. However, if we have a moderate and controlled move to higher yields in-tandem with a strong recovery, then stocks will do fine.
Mortgage rates, especially in the US (15yr and 30yr) should move in line with treasuries, but Canadian mortgages are somewhat protected seeing that many are shorter than 5yrs or are floating. Nonetheless, I’m sure you will continue to see Canadian banks raise their prime rate to take advantage of a hot housing market. Last time we saw an increase in yields, the housing market frothed over as people tried to lock in lower rates. Combine that with limited supply and the warmer weather, I suspect we will see similar behavior this spring.
Another sector to watch is the red-hot alternative investment world. Everything from SPAC’s to crypto to small-cap stocks to startups have benefited massively from a zero-rate environment that has saturated the market with cash/leverage and forced investors into riskier investments. As debt burdens and opportunity costs increase, can these markets maintain their incredibly high valuations? Only time will tell.
As for me, I believe volatility will lessen and we will see a more controlled move to higher yields throughout 2021. This, combined with twelve plus years of cheap money, should continue to drive asset valuations for years to come. There is no better time to be invested, especially with inflation rearing its head, you kind of have no choice; just choose wisely.
Jeyakumar Nadarajah is a Fixed Income Trader at Jefferies who is focused on relative value strategies within US Treasuries, Futures and Options.
This article is re-published from the March 2021 issue of “Street Talk”, TiF’s flagship publication. Interested in writing for us? Click here for our submission guidelines.