US bond yields are up ~60 basis points since their recent lows in mid-September. As is often the case, Australian long bond yields have largely tracked the upswing in US yields.
Equities have (for the most part) continued to push higher over this period, although last week saw the stock market advance begin to show some signs of fraying.
We think bond yields are at a fairly critical level, where any further lift would cause equities to retrace. In spite of this, our core view is that yields should pull back over the next few months, providing some support for equities. Importantly, the recent rise in yields has mostly been a function of a run of positive economic surprises, after a short-lived growth scare which pushed yields down quite sharply. This growth scare centred around a period when the US labour market showed some unexpected weakness. Indeed, this weakness in the US labour market (while short-lived) was sufficient to prompt the Fed to deliver a surprise 50 basis point rate cut in mid-September. This move fuelled market expectations of an aggressive Fed cutting cycle, which in turn drove a strong bid for US treasuries across the curve, with the US 10-year yield dropping to 3.6% down from its year-to-date highs of ~4.7% at the end of April.
Strong Data Lifts US Bond Yields
The Fed’s supportive policy actions meant that the August equity sell off was short lived. The Feds outsized cut was then followed by a run of better-than-expected economic data in October (September payrolls, September Services ISM and September retail sales to name a few). This data revival has helped extend the equity rally, although the strength of the data has significantly dampened Fed rate cut expectations, which has finally started to weigh on the equity advance over the past week.
While the primary trend of the past 12 months has been lower bond yields and a (strongly) rising equity market, volatility in respect of economic data releases has been a source of intermittment volatility for both interest rate and equity markets. Investors have been periodically worried by both “too hot” and “too cold” scenarios for the US economy driven by the ebb and flow of economic data releases.
Over the past year equities and bonds both sold-off significantly in September/October 2023 as US data surprised strongly to the upside. Indeed US (and Australian) 10-year yields hit a cycle high of ~5% last October. This proved to be an excellent buying opportunity as the data settled down again, allowing both bond and equities to rally.
April this year saw another bout of volatility, once again due to “too hot” fears in terms of both US economic activity alongside some stickiness in the US inflation data. Once again, the run of hot data faded relatively quickly, and equities & bonds rallied. More recently, the brief August equity sell-off was a “too cold” scare aggravated by the Japanese carry trade unwind. Encouragingly, the sharp rally in bond prices (lower yields) in August as equities fell restored the traditional role of bonds as a portfolio diversifier.
How Much Trump Effect?
Aside from the impact of economic data, the increasing probability of a Trump presidential victory may also be behind some of the recent rise in US bond yields and (particularly) the recent strength in equities. Indeed, it may explain the resilience of the US stock market in the last few weeks.
However, we can establish a clear link between the rise in bond yields as being attributable to strong data reining in expectations for Fed rate cuts. Expectations for Fed easing over the next 12 months has been reduced by around 60 basis points since mid-September. This is almost identical to the rise in the long-end of the yield curve over the same period.
What is the chance of no US landing?
From a fundamental perspective, the next six to 12 months should see bond yields trend lower, as growth and inflation both ease. The US presidential election does introduce the potential for more equity and bond market volatility, for both the short-term (regarding the election result) and possibly the medium-term for the path of the US fiscal deficit.
Recession risk has captured most of the headlines over the last two years (the US yield curve famously inverted 27 months ago). However, overheating /no landing concerns seem to be the greatest near-term tactical risk in our view.
A Trump win may push yields at least moderately higher, alongside a higher stock market, but there now seems to be a fair amount in the price of both asset classes for a Trump win, so such moves may well be muted.
While the US election result may have a short-term impact, fundamental data flows will continue to be critical to both bonds and equities. The US reporting season moves into full swing this week. The Fed’s preferred inflation gauge - the September Core PCE, is due on October 31, October payrolls are due on November 1, and the Fed’s next interest rate decision is due on November 7, just after the election on November 5. While the US has surprised on the upside recently, a moderate slowdown is still our base case. We have consistently pushed back against the US recession doomsayers, but we are reluctant to embrace the no landing thesis - at least at this stage. As we have shown, US data is inherently volatile, but the key is focusing on the underlying trends. US inflation is in a clear downswing. Economic growth is resilient and has accelerated in Q3, but we have\ witnessed this pattern before. We believe it should settle back to a slower pace in coming months. The US fiscal thrust is ebbing (at least for now).
The labour market is hanging in there, but showing clear signs of cooling (slower wage growth, fewer job openings, lower quit rates and a slower “trend” in payrolls growth). While the US consumer is solid, there are signs of fatigue outside of the most affluent consumers. Consequently, slower but reasonable growth remains our base case.
Soft landing still our base case
While we can’t rule out that a “too hot” scare will continue in coming weeks, a “no landing” scenario is not our base case. We expect a reasonably benign Core PCE reading, and a moderating labour market that should calm fears of a no landing scenario. A Trump win may fuel some anti-bond sentiment, but we think the economic data flow will ultimately dictate the path of US interest rates in coming months - at least until exact policy initiatives become clearer. Both US and Australian bonds look like good value at current levels. US and Australian equities are not cheap, but a US soft landing and lower US rates suggest they should continue to edge ahead in coming months. The Australian Dollar has eased back recently, as strong US data drives a broad based rebound in the greenback, but softer US data should see the A$ regain ground again.
Written by
David Cassidy, Head of Investment Strategy
David is one of Australia’s leading investment strategists.
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