US Federal Reserve Chair Janet Yellen. File Image: IOL
US Federal Reserve Chair Janet Yellen. File Image: IOL

US bond market scare - What now

By Opinion Time of article published Mar 1, 2021

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By Ryk de Klerk

In January I warned that the markets are vulnerable to any unpleasant surprises, and specifically the threat of rising inflation, and that inflation could overshoot on the upside.

The past week shocked many market players as long-term government bond yields soared in the US and elsewhere on Thursday with the US 10-year government bond index up by 16 basis points to 1.53 percent.

Emerging market equities as measured by the MSCI Emerging Market Index (US dollars) bore the brunt and ended the week down by 4.3 percent from its high on Wednesday while developed market equities (MSCI World Index in US dollars) succumbed by 2.4 percent.

Commodity-related currencies such as the Australian dollar and the South African rand lost 3.2 and 4.1 percent respectively against the greenback.

Market players and commentators attributed the rise to higher inflation expectations mainly on the back of impending accelerated growth on the back of vaccine rollouts and the much awaited economic stimulus to be finalised and implemented in the US.

The higher inflation expectations were not reflected in US 10-year Treasury Inflation Protected Securities (Tips) or the gold price though.

The Tips yield moved to minus 0.6 percent from minus 0.79 percent, while near gold futures at the close on Friday traded at $1 733 per ounce compared to spot market close of $1809 on Wednesday.

Mortgage rates in the US also jumped and are a major concern for the market as further rises in mortgage rates as a result of rising long-term bond rates could endanger the US housing recovery and the economy as a whole. It has to be seen in context though.

Since April 2009 the average 15-year mortgage rate was about 1 percent above the US 10-year government bond index yield and ranged between 0.5 and 1.5 percent.

The outbreak and the global crisis caused by the coronavirus saw the rate gap rising to more than 2 percent at its high at the end of March last year – within 80 basis points reached at the top of the Global Financial Crisis in 2008/09.At the end of December last year the rate gap remained at the upper level of the range since 2009 barring the crisis levels.

By the end of January this year the gap closed to the average since 2009 and the jump in US 10-year government bond yields and a minor jump in mortgage yields closed the gap even further to end the week about 30 basis points above the lower end of the range since 2009. What I am saying is that it should have been expected that the gap would be closed at some stage.

Looking forward, Yellen's skills and experience should not be underestimated as she was instrumental in the US recovery from the worst recession since the Great Depression.

The Fed's quantitative easing (QE) helped push down the unemployment rate over time and their main focus was to bring mortgage rates down to acceptable levels despite major fluctuations in US 10-year government bond yields.

Fifteen-year mortgage rates dropped steadily to 2.7 percent at the end of December 2012 from 6 percent in November 2008 and the slowing down (tapering) of the third stage of QE began a few months later. This resulted in rising long-term government bond rates as well as mortgage rates.You can expect Yellen to do her and her administration's utmost best to keep mortgage rates steady at the lower levels as it is critical for the US economic recovery.

The second stage of massive stimulus in the US is around the corner and inter alia encompasses QE by purchases of US government bonds.Therefore, you can expect relatively steady mortgage rates in coming quarters while yields on long-term government bonds are likely to stabilise at around the current levels, albeit nudging higher over time.

That is, until the Fed sees sufficient underlying strength in the broader economy to support ongoing progress toward maximum employment.

The gold price in terms of US dollars is inversely correlated with US 15-year mortgage rates – when mortgage rates increase, the gold price falls and vice versa, when mortgage rates drop, the gold price increases.

The expected continued low mortgage rates are therefore likely to underscore the current gold price.On a trade-weighted basis, the US dollar lost about 10 percent since March last year and is at the lowest levels since the end of 2014 after the surge following the ending of QE-3.

The Yellen-led quantitative easing after the global financial crisis kept the US dollar from rising and I think that we can expect a repetition of that going forward until the Fed is confident that economic growth is sustainable without any further quantitative easing. Yes, another positive for gold.

The prices of commodities and materials are already high and global growth could lead to inflation overshooting the US Federal Reserve's target of two percent.In December 2009, after the global financial crisis, the 10-year breakeven rate (a measure of average inflation over the next 10 years), calculated by adding the 10-year Tips yield to 10-year government bond yield, peaked at 2.5 percent.

If the break-even rate of 2.5 percent is revisited and the US 10-year government bond yield remains in a range of about 1 to 1.5 percent rising inflation expectations will therefore be reflected in the 10-year Tips bond yield falling.

The relationship between gold and the Tips bond yield indicates that we could see gold trading in a range of between $1750 and $2000 per ounce in coming quarters.That is, unless US inflation surprises on the downside which may see gold heading for a bear market. Was last week's scars on financial markets just scares or the shape of things to come?

Ryk de Klerk is analyst-at-large. Contact [email protected] His views expressed above are his own.

You should consult your broker and/or investment advisor for advice. Past performance is no guarantee of future results.

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