Long-term yields: How high is too high?

Thought of the day

by Chief Investment Office 08 Feb 2018

Volatility is the hot topic in markets now. But the equity pullback started on concerns about higher US inflation and bond yields. From this week’s low of 2.65%, US 10-year rates have already increased again to 2.8%. So the focus is likely to shift back to yields at some point.

There’s no one level that will cause problems for equities, in our view. And the economic impact of higher yields will be slow to materialize as borrowing costs roll over only gradually. But we’re watching a number of factors to judge whether bond yields are becoming an issue:

  • If stocks look less attractively valued than bonds. The global equity risk premium stands at 4.8%: if it compressed 140bps it would still be 3.4%, its average since 1990, suggesting equities retain their appeal.
  • If real yields move up significantly. So far, rising yields are largely down on higher inflation expectations – US 10-year breakeven rates are 2.1%, up from 1.75% in September – not higher real yields. Companies can manage this if they can pass higher prices on to customers. But if inflation is stable while borrowing costs are rising, this cuts into profits. Similarly, if wages are stable but borrowing costs are rising, this cuts into consumer spending.
  • If the market fears the Fed will tighten policy faster. Consensus estimates put longer-term rates at 2.75–3% after reaching 3–3.25% in 2020. If 10-year yields increase much above 3.25%, it might indicate fears that the Fed is falling behind the curve and needs to tighten faster.

As yet, we don’t believe yields are likely to reach levels that would prevent equities from moving higher over the next six months, but we will continue to monitor developments.

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