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The US 10-year bond yield – A Tale of Two Countries

Apr 19, 2021

• Low US 10 year bond yield either discounts trouble for growth, or reflects market inflation complacency
• Very recent surge in cases of a new variant of COVID-19 in India a concern for global markets
• Meanwhile in the US economy there are signs of potential inflation pressure
• Factors that could pressure for higher US wage inflation
• Rally in EM assets predicated on dollar weakness and low US yields that might not persist
• Gold and silver show signs of life

At the end of last week, we tried to get our heads around why the US 10-year government bond yield was settling back below 1.60%. In the US inflation data had been stronger than expected, most measures of economic activity are strong, President Biden is sending out regular cheques to every almost every household, and economists expect US growth of over 6.0% for the year.

Over the weekend, it was news from India that gave us an insight into why a US year yield of 1.60% could prove too high. In India, on April 17th, there were 261,000 new cases of COVID, up from 72,300 on March 31st. One-in-six people who underwent tests returned positive COVID results. The Indian authorities are reported to have sequenced a more aggressive variant that has two mutations. The variant has been detected in at least ten other countries, potentially undermining efforts for the world to get back to some kind of normality in coming quarters.

Chart 1: Daily change in new cases of COVID-19 in India

Putting the Indian COVID-19 news to one side for the moment, US economic data points to evident inflation pressure. Last week’s US consumer price inflation data was ahead of expectations. Headline inflation increased to 2.6% from 1.7% in February. Core price inflation rose from 1.3% to 1.6%. The following US CPI report for April is likely to show a further substantial boost to the headline inflation given that last year prices fell 0.7% month-on-month.

Many economists are still happy to say that all will be well and that inflation will drift lower as the year progresses. Their argument runs that US inflation will just deflate again in the absence of a significant rise in wage inflation. However, we see the making of more wage inflation pressure than we have seen for some time. The US small companies survey of ‘jobs difficult-to-fill indicator has risen to an all-time high. There is a growing concern that the stimulus cheques are disincentivising people from working, particularly in lower-paid jobs. Hence as the service sector starts to come back to life, they may have to pay up to hire the staff they need.

Chart 2: US small companies survey ‘jobs-hard-to-fill’

Even just going back to basic economics, US money supply growth measured by M2, which are cash balances that are readily available for spending and now up over 25% year on year, the highest recorded in the past 50 years. There comes the point when investors have to be wary about taking the bet that all of these initiatives will not work, that inflation will somehow remain beaten down.

Chart 3: US M2 money supply growth (%)

So, with the above factors in mind, we might try and rationalise why the US 10 year bond is trading below 1.60%.
If we think of the price of an asset as a weighted average of a series of possible outcomes;

Scenario 1. US inflation moves higher, and the 10-year bond yield normalises to the previous range of 2.50%-3.00%; assume 2.75% as the central point.

Scenario 2. A new variant of COVID-19 causes a significant delay to the recovery of the global economy, and hence we would envisage a 10-year bond yield of 0.75%.

A 50-50 possible outcome between the two scenarios gives us a ‘fair price’ for the 10-year yield of 1.75%. However, the current level of the 10-year bond (1.55%) implies a 76% chance of COVID creating more significant problems for the economy. Such a high probability of more COVID related issues is not priced into the equity market, with global equities up 10% since the start of the year.

The lower US year bond yield takes us back to the early days of the year when low bond yields and a benign dollar led to a sharp rally in emerging markets assets. The dollar fell 60bps on a trade-weighted basis in the last week, and emerging market equities were up 2.0% ahead of developed markets equities (+1.6%). Meanwhile, emerging market debt has benefitted from a rally in local EM currencies, a narrowing of EM debt yield spreads and a drop in US Treasury yields.

We have become more circumspect about the near-term prospects for EM assets. The divergence between Emerging Market growth and Developed market, with specific countries in the EM block particularly hamstrung by the combination of lagging vaccination rates and the emergency of newer COVID strains.
The slowdown in the Chinese economy is now more visible. It previously led most parts of the world in growth terms last year but has since been overtaken by the US. With the rebound in activity in the US now in full swing, market forecasts for Q1 GDP are 5% or higher. By contrast, China posted a slightly disappointing Q1 growth of 4%, a significant decline from the 14.6% pace in the final quarter of 2020.

Even more noticeable is the poor outcomes in other emerging nations. For example, Latin American growth negative for Q1 at -0.2%, led by Brazil and Peru. Emerging Asia is a mixed bag, with Korea lagging behind China. India has suffered the starkest of economists’ growth markdowns, where Q2 is now likely to show a contraction of around 15% (q-on-q). In response, investors are having a long hard look at some of the assumptions made about the Indian economy for the rest of 2021.

Note the improvement in precious metals last week. Gold rose 2.9%, and silver was up 5.0%. A weaker dollar and lower bond yields are obvious reasons for the rise in gold. However, it was the very strong US retail sales figures, the strongest monthly gain since May 2020, that pushed the price through resistance levels to a high of $1783.

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