William De Vijlder

For the first time since May 2019, 10-year Bund yields have moved back in positive territory. Three factors explain this development. Firstly, the traditional international spillover effect of developments in the US Treasury market where following a more hawkish tone from the Federal Reserve, yields have been on a rising trend since early December 2021. Secondly, markets are pricing the end of PEPP and the tapering of net asset purchases by the ECB.  Finally, there is the prospect that, at some point, the ECB will raise its policy rate. Bond markets in the US and Germany have become highly correlated since 2021. This is an important factor given the imminent start of a rate hike cycle in the US and its possible influence on Treasury yields and, by extension, yields in the euro area.

Several factors might explain current market behaviour in the face of higher inflation. Firstly, the high inflation is considered transitory. This is the belief of the central banks and it is shared by professional forecasters, who are collectively predicting that inflation will fall next year. The findings of the European Central Bank’s survey of monetary analysts and the US Federal Reserve’s survey of market operators are both along the same lines.

Successful market timing between equities and cash requires high skill levels. Very low official interest rates, through their impact on market rates, create a disincentive for doing market timing because they increase the break-even skill level. The same applies for quantitative easing. These considerations are important from a financial stability perspective. Growing investor reluctance to do market timing will probably lead to a decline in equity market volatility and an increase in equity valuations. The former provides a false sense of safety whereas the latter increases the sensitivity to negative news and hence increases the riskiness. 

The significant decline of Treasury yields from their peak at the end of March is puzzling given the growth forecasts and the recent inflation data. This suggests that investors side with the Fed in thinking that inflation will decline. It also reflects the weakening of data in recent weeks, which implies that markets focus more on the change in the growth rate than on its level. The sensitivity of bond yields to economic data moves in cycles. One should expect that, as seen in the past, a less accommodative US monetary policy would increase this sensitivity because these data will shape expectations of more tightening or not. Before reaching that stage, we should already expect an increased sensitivity in the course of 2022, because it is quite likely that inflation will remain above the FOMC’s target.

The following issues are discussed in this interview : is it time for Fed members to update the interest rate dots? Would that put Jerome Powell under pressure explaining how monetary policy can stay ultra-loose until the US returns to full employment? What problems US monetary policy is causing in the euro area.

While the US economy is in a good position to cope with a certain rise in long rates, in the euro area higher bond yields under US influence could have untimely negative effects.

In recent months, US government bond yields increased significantly on the back of higher inflation expectations but more recently, higher real rates have been the key driver. The latter development is in turn related to the prospect of massive additional fiscal stimulus. Unsurprisingly, the dynamics in the Treasury market have had global spillover effects, raising concern about an unwanted tightening of financial conditions.

Until recently, the rise in long-term interest rates did not stop the equity market from moving higher, but events this week suggest investors are becoming increasingly concerned. The possible impact of higher bond yields on share prices, depends on what causes the increase: faster growth, a decline in uncertainty, rising inflation expectations.The last factor is the trickiest one because it may cause a profound reassessment of the outlook for monetary policy. Over the past two decades, the relationship between rising rates and the equity market has not been statistically significant. Gradualism in monetary policy has played a role. Recent statements by Jerome Powell show he is very much aware of the importance of avoiding to create surprises.

Academic research shows that certain investors look at single stock call options as lottery tickets. They are aware they can lose money but nurture the hope of very big gains. To some extent, the share price behaviour in recent days of certain US small cap stocks illustrates this thinking. The combination of herd-type momentum buying and a short squeeze has caused huge share price swings. Should this become a recurrent phenomenon, it might reduce the informational efficiency of equity prices, increase the required equity risk premium and influence the cost of capital of companies.

 In recent months, the dollar has weakened versus the euro although the real bond yield differential between US Treasuries and Bunds has increased. Amongst the factors that may explain this development, Federal Reserve policy is particularly important through its impact on capital outflows from the US and currency hedging behaviour of eurozone investors. The biggest risk for a change in direction of the dollar would be a repetition of the ‘taper tantrum’ of 2013 with the Federal Reserve starting to point towards a possible beginning of the normalisation of its policy. However, such a change in guidance is not to be expected anytime soon.

Yields on US Treasuries and German Bunds tend to be highly correlated but since the end of August, Bund yields have been essentially stable whereas treasury yields have increased.This spread widening is explained by a rising real rate differential, to a large degree due to a decline in German real yields. This could reflect a more gloomy view of bond investors about the growth outlook in Germany and, by extension, the Eurozone. Another, more likely, interpretation is that the real rate risk premium has declined in Germany due to the asset purchases of the ECB. In such case, investors will become increasingly nervous about the prospect that in a post-pandemic world the ECB will eventually have to stop the net purchases under its PEPP.

It is quite likely that, going forward, fighting recessions will be the remit of governments with central banks facilitating this task by creating cheap financing conditions. As a consequence, public indebtedness may very well remain high.One should wonder whether this could end up having negative consequences. A possible transmission channel is the pricing of government debt via a sovereign risk premium. Another factor can also play a role. Since 2015, when German bond yields increased, the rise in Italian yields has been even bigger -so the spread widens- whereas French yields have increased in line with German yields. These results suggests that, even in an environment of public sector securities purchases by the ECB, the high level of Italian debt influences the reaction to movements in Bund yields. Clearly, in the absence of QE, one would expect this effect to be at least as powerful.

In the US, the behaviour of the equity market versus the level of employment is very different in the current recession compared to previous recessions. The recession this year stands out because of its sudden, enormous job losses, which were quickly followed by a significant albeit very incomplete recovery. The equity market, after a huge drop, has rebounded swiftly and made new highs although earnings –on a 12 month moving average basis- still have to rebound. For 2021, more than anything, earnings growth matters.

The very good performance of stock markets since the announcement that an effective vaccine was under development, may surprise. If GDP growth in 2021 is expected to be less dynamic than anticipated (before the announcement of a vaccine), how to account for equity markets rally?

The publication by the ECB of different economic scenarios illustrates the extent of uncertainty which at present surrounds the forecasts for key macroeconomic variables. As a consequence, companies may hold off investing, preferring to wait for better visibility. While understandable at the micro level, such a wait-and-see attitude could act as a drag on growth and reinforce the view of companies that their caution was warranted.The large increase in the dispersion of earnings forecasts points to huge uncertainty at the individual company level. However this has not stopped the US equity market from rallying. Although several factors help to explain these different reactions to uncertainty, such dissension cannot last forever. At some point company cautiousness or investor bullishness will have to give in.

Fed Chair Powell’s comment about what would happen in case of a prolonged recession has weighed heavily on equity markets. Historically, recessions are accompanied by major equity market drawdowns. The year-to-date decline is more limited, which stands in stark contrast with the plunge of activity. Massive monetary and fiscal policy support has led to a reassessment of the distribution of risks, which goes a long way in explaining the rebound of equity markets. The focus is now shifting to the outlook for corporate earnings, hence the importance of the debate on the shape of the recovery.

In theory, and all other things being equal, an increase in uncertainty results in a fall in the price of risky assets and an increase in the price of safe haven assets. In a way, this can be considered as the “price of uncertainty”. The reality is rather more complex. Greater uncertainty also affects growth prospects, which in their turn influence asset valuations.

Economic sciences teach us that financial markets fear uncertainty as it introduces volatility in prices of financial assets. Based on the reaction of markets since the beginning of the year, one could conclude that economic textbooks need to be rewritten. In spite of a high level of commercial and geopolitical uncertainty, markets have recently set new records.