Bond yields higher again, as reflationary sentiment dominates. S&P500 down slightly, but big gains for cyclical and small cap stocks. USD lower despite higher US real yields. NZD up to 0.73, AUD makes a fresh three-year high

Global bond yields continued to move sharply higher on Friday, with the US 10-year rate hitting its highest level in 12 months and yield curves steepening.  The increase in global rates saw the S&P500 give up earlier gains and close marginally down on the day.  The reflation theme continues to drive sector rotation in equity markets, with small cap and cyclical stocks outperforming.  Surprisingly, the USD didn’t benefit from the sharp increase in US real yields.  The AUD made a three-year high on Friday while the NZD hit 0.73.  

The reflation trade continues to drive markets, as investors see the potential for Biden’s ginormous proposed fiscal stimulus (~9%/GDP as it currently stands) to turbocharge the global economic recovery this year.  Bond yields, a key barometer of reflationary expectations, continue to head higher across major markets.  The US 10-year yield rose to as high as 1.36% of Friday, before settling back to 1.34%, still 4bps higher on the day.  10-year yields in the UK and Germany were up 8bps and 4bps respectively, while the 10-year yield in Japan breached 0.1% for the first time since November 2018.  New York Fed President John Williams told CNBC he wasn’t worried about the increase in bond yields, as he saw the move reflecting investors’ optimism over the economic outlook.  

There wasn’t much fresh news on Friday to drive the price action.  The European PMIs showed continued divergence between a booming manufacturing sector and a services sector languishing due to lockdowns across the region.  The German Manufacturing PMI reached a three-year high of 60.6 while its Services PMI fell to a nine-month low of 45.9, still in contractionary territory.  The US PMIs produced by Markit tend to get less attention from market participants than the ISM surveys, but these too remained at lofty levels.  The prices paid component in the US reached its highest level since 2009, indicative of growing inflation pressures (including from commodity prices).

Adding to the upward pressure on rates, academic heavyweight and former Treasury Secretary Larry Summers wrote that the Fed could be forced into raising rates next year.  Summers, who has respect in the market after correctly predicting that interest rates (pre-Covid) would remain low due to the forces of ‘secular stagnation’, has criticised the US fiscal package as being poorly targeted and something that could lead the economy to overheat.  

Elsewhere, Pfizer/BioNTech said their Covid-19 vaccine could be safely stored for two weeks at normal medical freezer temperatures, rather than the ultra-cold temperatures they previously advised.  This should help with the logistics of distributing the vaccine.  Separately, an Israeli study showed that a single shot of the vaccine was 85% effective, good news for the UK which has been spacing out its doses for longer than the recommended three weeks.  

Equity markets were higher in Europe and the early part of the US trading session.  But the S&P500 then drifted lower to close marginally down on the day (-0.2%), with the increase in bond yields no doubt weighing on equity market sentiment.  In contrast, the Russell 2000 index, comprised mainly of smaller companies exposed to the domestic US economy, was up 2.2%.  The S&P500 is up 4% year-to-date while the Russell 2000 is up 15%.

Within the S&P500, sector rotation continues. Cyclical stocks made strong gains, with the materials, energy and industrials sectors up 1.6-1.8%, while the financials sector rose 1.2%, with higher interest rates and a steeper yield curve (alongside expectations of a strong economic recovery) perceived as supportive of banks’ net interest margins.  In contrast, high dividend stocks, which investors have poured money into in recent years as substitutes for low yielding bonds, underperformed.  The utilities sector was down 1.5%.

Going against the grain of the reflationary sentiment and recent moves, there was a pull back in US market-based inflation expectations (so-called ‘breakeven inflation’).  US 10-year breakeven inflation fell 2bps, to 2.16%.  Combined with the moves in nominal rates, this translated into a 6bp increase in the 10-year US real yield, to -0.82%, and a 9bp increase in the 30-year real yield, to back above 0%.

The increase in US real yields surprisingly didn’t provide much support to the USD, which was broadly weaker on Friday.  The BBDXY index was down 0.2%, cutting its gain on the week to 0.1%.  The depressed level of US real yields has been a key plank of the weak USD thesis, a widely held consensus view, so it’s possible the USD finds some support if US real rates continue to head higher.

The big movers in currency markets on Friday were the AUD and NZD.  Compared to 5pm NZT on Friday, the AUD is more than a cent higher.  It closed the week at a fresh three-year high, around 0.7870.  Likewise, the NZD appreciated over 1% on Friday, closing around 0.73.  Strengthening commodity prices (copper was up more than 4% to an almost 10-year high), expectations of a synchronised global growth expansion, and still-buoyant risk appetite have all supported the NZD and AUD.

Currency moves elsewhere were more modest.  The GBP broke above 1.40 for the first time since early-2018, with the market looking favourably on the UK’s relatively fast Covid-19 vaccination roll-out (over 17 million have now received a dose).  PM Johnson is expected to set out his ‘road map’ to reopening the economy in a statement to parliament tonight.  The market brushed off a very weak UK retail sales release, which showed spending plunged in January.

NZ rates edged higher on Friday, with the 10-year swap rate and government bond yield increasing 2bps, to 1.6% and 1.51% respectively (both around 12-month highs). But we can expect another big move higher today with the yield on the Australian 10-year bond future about 10bps higher than the time of the NZ market close on Friday.  The price action is a reminder that central bank forward guidance and QE tend serve to slow, rather than prevent, movements in wholesale rates when fundamentals shift.  The market is pricing the first 25bp rate rise by the RBA in early-to-mid 2023 despite the RBA recently saying it didn’t expect to raise the cash rate until 2024 “at the earliest”.

For the week ahead, the highlight is the RBNZ MPS on Wednesday.  The Bank will need to acknowledge the unquestionably stronger economic data over the past three months, but we expect it will maintain a cautious stance, conscious there are still some downside risks lurking.  We think it’s likely the Bank reaffirms, at this stage, that it will buy bonds under its QE programme until June 2022, although we will be listening for any guidance from the MPC around its likely future pace of purchases.  It’s possible the RBNZ pushes back against market pricing for a 25bp rate hike by the end of 2022 but, given the market is now pricing rate hikes for the Fed and RBA by mid-2023, we suspect the market reaction might be quite short-lived. 

Offshore, Chair Powell will testify to the Senate on Tuesday and House on Wednesday.  He’s likely to be pressed on the Fed’s opinion of Biden’s proposed stimulus and how it might react.  There is only second-tier data released.