The bear market in bonds is over for the time being and Goldilocks is back. That much is clear from a look at what is driving US Treasury yields.
Treasuries trade in two components, ordinary coupon securities and inflation-indexed securities, or Treasury Inflation Protected Securities (TIPS). The difference between the coupon and TIPS yield is the inflation rate at which the two instruments will return the same amount.
That’s a pretty good proxy for expected inflation (as measured by the US Consumer Price Index) over the life of the security.
Since the election, expected inflation (or “breakeven” inflation) has traded tick for tick with oil prices.
Oil is up about 20%, and 5-year “breakeven” inflation is up about 20 basis points. Oil is going nowhere from here: once oil hits the mid-US$50 range, US shale producers come back on line and increase supply. As many industry analysts point out, the additional supply triggered by higher prices puts something of a cap on the oil price.
The TIPS component of US Treasury yields, meanwhile, rose as investors expected higher economic growth under the incoming Trump Administration, stimulated by lower corporate taxes and higher US infrastructure spending. Higher growth expectations are gauged by a rise in the estimate for the Federal Reserve’s overnight interest rate 12 months ahead, which trades in the futures markets.
The market has priced in an additional 25 basis points of Fed tightening due to higher expected growth, and the US 5-year Treasury yield rose about 30 bps. The market will have to see evidence of much higher growth before it moves further, and that will depend on the new Administration’s success in selling its economic agenda to Congress.
That dust won’t settle until late in 2017.
The dollar rose sharply with US yields. In the case of the euro, the difference between US and German bond yields tracked the euro’s parity with the dollar almost perfectly.
The US yield curve also steepened sharply (longer-date yields rose more than short rates), benefiting banks. US banks’ equity prices rose by nearly 30% after the November 8 election, in line with a global rally in the sector. The price-earnings ratio of US banks jumped from 12X earnings before the election to over 15X at present, still lower than the overall market price-earnings ratio of 20, but fully priced by historical standards. If the yield jump is over, as I believe, the bank rally probably has reached its use-by date.
This is a benign situation for equities, especially for equities that are likely to do well if the Trump White House succeeds in bolstering US industrial employment and energy investment.
It’s a tricky market, to be sure. Tech companies dependent on a global supply chain have lost ground, and aerospace companies likely to benefit from higher defense spending suffered when the president-elect tweeted his displeasure with the cost of defense procurement.