US market sentiment weakens amid bond yield and inflation concerns

Markets remain focused on the US 10-year bond yield as it fluctuates around the 1.5 per cent level, largely determining how equities perform and strengthening the dollar. In the UK, however, we are seeing a glimpse of the likely direction economies and policies will take once the coronavirus pandemic is over.

US equity markets bounced back at the end of last week despite non-farm payrolls jumping by 379,000 in February, causing the 10-year yield to test 1.62 per cent before slipping back to 1.56 per cent. Major equity indices struggled initially after the employment data but were able to recover as bond markets avoided a complete tailspin and the S&P 500 ended Friday’s session up 1.95 per cent.

However, the dependence between bond yields and broader markets – such as equites and the greenback – remains evident. The US Federal Reserve is taking a relatively relaxed view of the firming in Treasury yields, saying they are consistent with an improving economic outlook.

With little sense of urgency to push back against yields, equity market sentiment is apprehensive in case they rise towards 1.75 per cent or even 2 per cent, potentially creating volatile market conditions.

This could happen if bond investors become less confident that the Fed and Treasury are in control of events and following appropriate policies to keep inflation in check. Investors know that the Fed is prioritising the objective of maximum employment and is ready to “over-accommodate” in terms of policy support by letting the inflation rate overshoot.

But with US real gross domestic product growth expected to be 7 per cent this year – as the US budget deficit reaches $3.5 trillion and M2 money supply growth, a broad measure that includes cash and deposits to help gauge inflation, runs at 25 per cent – markets are acutely aware of the risks that inflation might start to run away.

The Fed’s policy option of choice in the event of a disorderly sell-off in bonds would probably be yield-curve control or some form of “Operation Twist”, in which it keeps the short end of the curve pegged close to zero while moderating the yield curve steepening at the longer end.

Equities are hesitant and the dollar has begun to firm, especially against currencies where the prospect of monetary tightening is more remote, such as in the eurozone, Japan and the UK.

This has challenged widespread perceptions that the dollar could weaken this year, which were based on more conservative assumptions of where bond yields would stabilise.

While markets ponder the post-Covid-19 landscape and outlook, the UK provided further signals about what might be in store with its 2021 budget. Given that the UK is ahead of most other developed countries in the vaccination process, its projections about the recovery and the policy options that might be adopted have particular relevance.

The budget reflected a phased approach to repairing public finances by doubling down on support initiatives and spending over the next two years before a second phase of big tax increases is enacted.

The end game will result in Rishi Sunak, Chancellor of the Exchequer, taxing 35 per cent of the UK’s GDP by 2025, a burden not seen since the late 1960s, with increases in corporate tax rising from 19 per cent to 25 per cent – and responsible for the brunt of the austerity.

However, as with most budgets, the reality of what will unfold will depend on the performance of the economy in the coming years. It is already apparent that changing economic assumptions may make the situation quite different.

Because of the UK’s successful vaccination drive, the economy is expected to grow faster in 2022 than previously thought. GDP is also expected to return to its pre-crisis level in the middle of 2022, rather than towards the end of it. This could be revised earlier still, giving the government enough room to ease the tax hikes that are currently envisaged.