Treasury yield spike risks sparking domino effect

ONE of the year's biggest spikes in Treasury yields has investors mapping out the impact of rising rates on markets ranging from stocks to corporate bonds.

Renewed optimism about US stimulus talks pushed the benchmark 10-year yield to a high of 0.94 per cent on Tuesday, a move which if continued, could spark a domino effect across risk assets trading at all-time highs thanks to low interest rates. At issue is whether the jump in yields is accompanied by an economic recovery and moderate levels of inflation that would allow the Federal Reserve to keep rates low.

So far, it seems investors are positioning for that scenario, with the Treasury curve steepening overnight and US stocks rallying to a fresh record. Ten-year breakevens - a measure of the market's inflation expectations - rose to their highest level since May 2019.

"A range of one to 2 per cent is certainly possible and it would have wide implications across everything from emerging Asian currencies to commodities," said Vishnu Varathan, head of economics and strategy at Mizuho Bank in Singapore.

Benchmark yields have tripled from their March lows on bets of a global economic recovery and a "return to normal" from the pandemic with the help of vaccines. A Bank of America survey last month found a record 73 per cent of investors expected a steeper yield curve.

Here's what higher Treasury yields could mean for various asset classes:

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Skyrocketing stocks: One of the clearest winners from a modest rise in Treasury yields could be equities, particularly those most exposed to a reflating economy. The MSCI AC World Index is already trading at a record and rotation to cyclical shares such as industrial and materials names accelerated last month.

"To the extent yields rise, it's likely to be on higher inflation expectations," said Andrew Sheets, cross-asset strategist at Morgan Stanley. "Periods where yields were rising and the yield curve is steepening - those are some of the best periods for the stock market." But key to the bullish outlook for stocks is inflation staying under control and economic growth. A return to the dreaded stagflation of the 1970s for example, would quickly derail any rally in risk assets.

"You cannot rule out inflation returning - it could creep up on us through 2021, 2022," said Stephen Miller, an adviser at GSFM, a unit of Canada's CI Financial Group. "Yields will climb further and make it harder for central banks to control their yield curves, which will certainly create headwinds for equities and make them vulnerable to a reasonably significant correction."

While higher Treasury yields have traditionally triggered a selloff in emerging market bonds and currencies, 2021 may prove different, said strategists. Because the recent climb is linked to improved economic prospects, it's also positive for developing nations, said Khoon Goh, head of Asia research at Australia and New Zealand Banking Group in Singapore.

"With the Fed expected to keep policy very accommodative for some time, there is nothing for EM to fear at this stage," he said. Case in point is Indonesia, whose 10-year bond yield plummeted last month as investors snapped up higher-yielding and growth-sensitive assets. The rupiah is also Asia's best-performing currency in the past month, rallying over 3.6 per cent against the dollar.

Most Asian currencies are also likely to "face a limited impact or even strengthen against the dollar", said Mitul Kotecha, a senior emerging-markets strategist at TD Securities in Singapore. "Higher US yields could be a reflection of stronger US economic prospects, which would be beneficial to Asian economies, but would be less supportive of the dollar."

Gold hold: The outlook is a little less certain for gold. If a rise in Treasury yields to 1 per cent or higher "is due to a reflation trade, then inflation breakevens - gold and gold miners, commodities, will do well usually," said Societe Generale SA strategist Sophie Huynh.

But further gains in yields might also hurt the yellow metal as demand for haven assets wane, said Ken Peng, head of Asia investment strategy at Citigroup Inc's private-banking arm. Gold traded around US$1,810 on Wednesday.

Credit bonanza: Like equities, the credit market may also stand to gain from higher Treasury yields.

Debt investors have been clamouring for longer-term US corporate bonds as stimulus spending bolsters risk appetite, sending spreads on notes maturing in 10-years or more to their tightest since February.

Credit spreads should remain tight as long as the move higher in Treasury yields is due to a reflation trade, SocGen's Ms Huynh said.

Dollar hit: Higher Treasury yields could end up weighing on the world's reserve currency. Should the US yield curve steepen as inflation expectations rise, "this will incentivise investors to currency hedge", Citigroup strategists said. Moves by investors to shield from currency fluctuations in US investments could see the dollar fall by as much as 20 per cent next year, they said.

Goldman Sachs Asset Management's James Ashley, who also sees potential for more curve steepening, is forecasting a weaker dollar against emerging currencies such as China's yuan.

Fed reaction: Still, much will depend on the response of the Fed to any spike in US yields, particularly amid the ongoing debate on its asset purchase programme and expectations that it will let the economy run hot.

The Fed is currently buying about US$120 billion in Treasuries and mortgage-backed bonds every month, partly aimed at lowering borrowing costs for businesses and households. BLOOMBERG