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Taper Tantrum II – Bond markets went rogue around the world

Nearly every asset class felt the pain. What does it mean for you and the markets?


 

Our Top Market Takeaways for February 26, 2021.

Market roundup

Wait, what just happened?

Interest rates went rogue around the world and prompted a selloff across pretty much every major asset class. Let’s break it down.

  • Global government bond yields rose aggressively, at just about every part along the yield curve. In the United States, the selloff was led by the 5–7 year part of the Treasury curve—where rates rose 20 basis points (bps). The 5-year Treasury yield hasn’t risen this much since the Global Financial Crisis, when rates were 200 bps higher (i.e., there was more room to move). And the Treasury had a really hard time selling bonds at its auction, suggesting that price-sensitive buyers didn’t think yields looked attractive enough to buy.  
  • Rates have been rising all year, but yesterday was different. We have argued that bond yields were moving higher for the “right reasons”— with the bulk in the move driven by a recovery in inflation expectations (the light green line in the chart below). The idea was that more workers would become employed, actual inflation would recover and rise, and the Fed would move very slowly in eventually raising rates. The problem with the moves recently is that they have been driven by “real” interest rates (green line in the chart), which are indicative of what the market thinks about the Fed’s plans on raising rates. The market is challenging the Fed’s communication that it will remain supportive

 

  • To look at it a different way, markets are now expecting the Fed to start raising rates in the first half of 2023 (versus the first half of 2024 at the start of the year), and they also expect the Fed to be more aggressive once they start. Markets now expect three more hikes by the end of 2024 than they did at the beginning of the year. 

 

  • There was also likely real pain in the hedge fund community that was focused on interest rate trades. Volatility went through the roof, and those that had leverage likely had to unwind trades—a dynamic that forced even more selling. Not to mention that market liquidity and depth were poor and added to wonky market functioning. (Sound familiar? Stocks and bonds may not be so different after all.)

Rising real yields are much harder for risk markets to tolerate because they suggest that risk-free assets are becoming more competitive with risky assets. This matters for valuation, and especially the valuation of secular growth stocks that are more sensitive to moves in interest rates because more of their cash flows are expected further in the future. The Nasdaq 100 has fallen over 7% from all-time highs, and more froth has been blown off the top of other areas such as SPACs (-14% from highs), Bitcoin (-20% from highs), and retail favorites such as the ARK Innovation ETF (-19% from all-time highs).

So what does all this mean? We have good news and bad news.

Let’s start with the bad. The rapid rise in bond yields is spooking equity markets. It’s hard for the equity market to have low volatility when the bond market has high volatility. Rates markets are like the foundation of a house—when they are shaky, it’s hard to feel comfortable. It’s also concerning that the Fed is getting challenged on its commitment to easy policy. It’s a core tenet of our positive outlook, and the Fed’s leadership seems committed to achieving the goals set out in its new framework (namely, maximum employment across different groups, and inflation that averages 2% over time).

Now for the good. We think this market behavior is ultimately consistent with a shaky transition from a “hope” phase (where markets are reacting almost exclusively to expectations for a brighter future) to a “growth” phase (where boring stuff—such as GDP, profits, inflation and employment—drives markets).

Equity returns come from three sources: the change in valuation, the change in earnings, and the dividend. In a hope phase, valuations expand because markets are hopeful for a more positive future, and they drive price gains. As we move into the next phase, we expect earnings growth to drive appreciation. Falling interest rates (and especially real yields) were a tailwind to valuations, and they have become a headwind. However, we are about to see a new earnings tailwind from the strongest economic growth in 30 years.

In fact, this episode is eerily similar to the Taper Tantrum of 2013, when bond yields surged following then Fed Chair Ben Bernanke’s statement that it would be appropriate for the Fed to reduce bond purchases. The market took it to mean tightening, and near-term hike expectations surged by a 1.4%. Flash forward to today. Near-term hiking expectations are up by 1% over a similar time period, and the yield curve has steepened by a similar amount. Beyond the similarities in the bond market, the Taper Tantrum happened during a “hope” phase for the equity market.

What happened after the Taper Tantrum? Just six more years of economic expansion and market gains. Past isn’t always prologue, but the bond market action this week does not indicate to us that the end of the good times are here. We just think we are progressing slowly through the different phases of the economic and market cycle, and markets are acclimating to the change.

 

Ultimately, we are siding with the Fed, and think we can find opportunity in the volatility. We think that expecting a hike in the first part of 2023 is too aggressive. Remember, the Fed needs employment to fully recover. And not just the unemployment rate. The Fed seems committed to improving labor force participation, too. Then, it needs inflation to average 2% over time. Markets may think this is likely, but actual inflation hasn’t shown up yet, and 2021 is not going to provide a clean read because of the base effects from 2020.

Oh! And don’t forget: There are a lot of steps to go before the Fed actually tightens, anyway. It also needs to: 1) talk about tapering bond purchases; 2) actually taper; 3) talk about hiking rates; 4) actually hike rates. Recall that after the Global Financial Crisis, this whole sequence took more than two years! We are two years away from Q1 2023 now, and as Powell said, the Fed is in no rush.   

  1.  Reimagine the bond portion of your portfolio. We did not think this year would be kind to core fixed income, and that is playing out even more painfully for core bond investors than we expected. We encourage investors to have a conversation with their advisors about whether or not their bond allocations are still providing the protection and income they expect, or need, to meet their goals.
  2. Consider exposures in cyclical areas that are backed by megatrends such as financial technology, clean energy, semiconductors and emerging markets.

Bond markets are throwing a tantrum, but as anyone who has spent time with children knows, tantrums are temporary.

 

 

 

 

 

All market and economic data as of February 2021 and sourced from Bloomberg and FactSet unless otherwise stated.

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