Cear steepening yield curve poses risk to markets

HERE is the thing. In the United States, the long-dated treasury yields for both the 10-year and 30-year have been rising steadily since hitting the lows last year and well into this year, especially so the past one week.

For example, the yield on the 10-year US treasuries are up, from a low of 0.5% last year, and the start of the year at 0.92%, to the current level of 1.53%. This represents a jump of 103bps and 61bps respectively.

For the 30-year, the yields have moved from the low of 0.94% in 2020 and 1.65% as at end of last year to its current level of 2.30%, an increase of 136bps and 65bps.

At the same time the short-term three-month US treasury papers have barely moved. The threemonth US treasury moved year-todate in fact is lower by 4 bps as it was last seen at 0.03%.

What has occurred is that the yield curve has in actual fact steepened or what is referred to in the market as bear steepening, which is a result of long-end papers rising at a faster pace than the short-end.

Chart 1 shows the peculiar relationships between the three papers and a bear steepening curve typically occurs during recession and is a sign that the era of low interest rates is ending as market prices in, not only economic recovery, but rising inflation expectations.

The rise in inflation expectations is driven by few factors and of course the primary factor is the economic recovery path that all of us are expecting this year.

With the vaccine being rolled out in huge quantities hitting about 225 million doses to date across almost 100 countries and with the United States alone reaching about 20% of its population, expectations are high that some sort of economic normalcy will return and growth will be strong, especially into the second half of 2021, and going into 2022.

At the same time, inflation expectations are also rising due to a increase in commodity prices.

Based on Bloomberg Commodity Index (BCI), which is the most widely used commodity benchmark. Comprising of 23 exchange-traded contracts on physical commodities, the BCI is up by 11.6% year-to-date.

The biggest gains come from the rally in oil, which is up 29% this year followed by copper’s 21% rally.

The rally seen in commodities is driven by two main factors: one is the weather patterns, which have disrupted oil production in Texas and other parts of the United States, as well as demand growth, as the economy opens up with freer movement of people and goods.

Real yields are rising too

Another tell-tale sign for the market is the treasury real yield curve rates. Real yields on Treasury Inflation Protected Securities (TIPS) at “constant maturity” are interpolated by the US Treasury from the daily real yield curve.

Latest data showed that the real yield is now at -0.60%.

Hence, with the 10-year last seen at 1.53%, the break-even point for the 10-year US treasuries is at 2.13% – a level which is fast rising and highest since August 2014.

This 2.13% rate is effectively the rate of inflation the market is pricing over the next 10 years and this expectation has been rising steadily from the low of just 0.47% at the trough of markets in March last year.

Hence, while the Federal Reserve remains comfortable on current benchmark Fed Fund Rate at between 0.0% and 0.25%, market is beginning to price in that the Fed will have to raise rates sooner or later.

Although its not going to be soon, as current inflation rate is at just 1.4% – well below the Fed’s target of 2% and job market remains challenging, the Fed will have to look at what the market is expecting in the future to ensure that it remains ahead of the curve and not behind.

A gauge of rate hike expectations showed that market is not pricing in any rate hikes this year.

However, the implied rate hike odds from 2022 to 2024 are telling as the Fed is expected to raise rates four times over the three years period. This has led the market to correct rather significantly at the long end of the duration with the biggest move seen in the 10-year and the 30-year.

Investors turning risk adverse on rate moves

The recent selling pressure in the equity market, in particular the tech sector and cryptocurrency space has been attributable to the sell-off in the bond market.

Investors are concern that with rising inflation expectations, as judged by the fixed income market, could pose risk to lofty valuations seen in some of the recent outperformers.

The only driving force for the market for the time being seems to be the much awaited Biden’s US$1.9 trillion stimulus package, which includes direct financial aid to average Americans, support for businesses and to provide a boost to the national vaccination programme.

In addition, the Fed’s chair, Jeremy Powell, also testified that the Fed was nowhere close to pulling back its support for the US economy as the economy remains “a long way from employment and inflation goals”. The Fed, which is currently buying Us$120bil of assets per month, remain committed to sustain its buying programme “until substantial further progress” has been made toward its goals of maximum employment and 2% inflation.

So, while we have inflation expectations rising, as seen in the bear steepening yield curve, the

Fed on the other hand promises to keep the economy (read as the market) going with its bond buying programme. The key, as most market watchers have pointed out is to watch the 10-year US treasuries as it is now above the 1.5% and nearing the 1.6% mark, a level that is seen as critical for equity market’s potential trigger point for an equity market leg down.

cank Negara likely to stay pat

The Malaysian central bank is expected to have its second Monetary Policy Committee (MPC) meeting for the year next week and all eyes will again be on MPC as to whether there will be a 25 bps cut or otherwise. With the current recovery that we are seeing in the domestic economy and more economic sectors opening, it is likely that the MPC will wait for further evidence of economic data points to make any decisions on rates.

Hence, it is rather unlikely to see a rate cut next week. The January 2021 inflation rate of -0.2% suggest that the rate of deflation is reversing, having recovered from last year’s devastating reading of -1.2%.

Inflation is expected to return this year with headline inflation likely hitting at least 2% to 2.5%, driven by the low base effect and a surge in fuel prices.

The movement in global bond yields have also cause some jitters on the local bond market as the yield on the 10-year benchmark MGS has moved from 2.65% at the end of last year to above 3%. Given the bond market dynamics, the rise in long bond yields have caused significant melt-down with the current global negative yielding total debt falling to about US$12.6 trillion from a high of US$18.4 trillion less than three months ago.

The steepening of the yield curve has indeed resulted in significant damage to markets and it could get worse if the 10-year moves beyond the 1.6% mark – a level seen prior to the global pandemic last year.