Surging yields on U.S. Treasury bonds are being felt around the globe, as investors reshape their portfolios to take advantage of higher interest rates in the world’s largest economy.
After two years of extraordinarily easy money, Treasury rates have shot up in recent weeks. Their rise has taken a toll on currencies, stocks and bonds in emerging markets such as India, Indonesia and Thailand, as a bet on those economies suddenly looks less attractive in comparison to the yields now available in the United States.
Yields on Treasury bonds are still low in historical terms but are much more attractive than they were just a few months ago. The payout on the benchmark 10-year Treasury bond hit 2.9 per cent on Monday, its highest point since 2011.
While the yield slipped slightly to 2.8 per cent on Tuesday, it still stands more than a percentage point higher than it did in May. Rates in most other developed nations are rising too, with the 10-year Canada bond closing at 2.7 per cent on Tuesday, up from under 2 per cent at the start of the year.
As higher rates make it more appealing for investors to hold Treasuries and other developed-nation bonds, investors are pulling money out of emerging markets. The main Indonesian stock index has lost more than 10 per cent of its value over the past five days, while Indian and Thai stocks are also down.
The effect of rising bond yields on stock markets in countries such as Canada and the United States is harder to pin down. Higher yields reflect growing economic optimism, but they also raise borrowing costs for companies and make fixed-income investments look more attractive in comparison to equities.
Market strategists are trying to assess how high rates may climb. The driving force behind the recent increase has been the growing expectation that the Federal Reserve will start tapering its massive bond buying program, known as quantitative easing, perhaps as early as next month.
Bond yields move in the opposite direction to bond prices, so less bond buying from the Fed would translate into lower bond prices and therefore higher yields. In addition, Fed chairman Ben Bernanke is expected to step down early next year and his replacement may take a tougher line on raising interest rates.
“The biggest risk to the bond market ... is the combination of tapering fears and the election of a more hawkish chairperson,” George Goncalves, head of U.S. rates strategy at Nomura Securities, said in a note, in which he forecast yields on the 10-year U.S. Treasury could rise “meaningfully” above 3 per cent.
“At such extreme levels, we believe that stocks would be under even more pressure as bonds become competitive again.”
The speculation over the Fed's next move comes as central bankers gather later this week in Jackson Hole, Wy., to debate monetary policy and the global economic outlook. The tapering could begin in September and end by mid-2014, according to the median estimate in a Bloomberg survey of 48 economists conducted last week.
The yield on the 10-year note could rise as high as 4.2 per cent, according to a report from S&P Capital IQ chief equity strategist Sam Stovall.
He points out that the 10-year yield has typically been about two percentage points higher than the consumer price index. with the CPI is currently at 2 per cent, the historical relationship suggests the 10-year yield should be over 4 per cent – a massive increase from today’s levels.
But Mr. Stovall thinks such a rise in unlikely given the relatively weak economy. The 10-year Treasury yield has also typically been about half a percentage point below the growth rate of nominal GDP – a relationship that suggests the yield should now be around 3 per cent, only slightly higher than current levels.
He is betting that the yield will stay closer to 3 per cent, “as we still see the U.S. economy facing headwinds that will likely keep it chugging along at a slower-than-normal pace.” Unless there’s a surprising lift in the U.S. recovery, Mr. Stovall believes the impact on stocks will be minimal.
Caldwell Securities Ltd. portfolio manager Chris Coderre said his firm is starting to buy bonds after the recent increase in yields, but noted the firm isn’t selling stocks to finance the purchases.
“We think the opportunities are way more attractive on the equity side,” Mr. Coderre said. He pointed out that the dividend yield on many stocks is still higher than bond yields.
“If the North American economies do better you would want to own stocks to participate in that increase in activity,” he said.