The last few weeks have seen US yields breakout to the topside of the tight range they have been trading in. The market narrative is that yields have been boosted by more clarity on the US election – a Democrat win with a mooted $3.5 trillion stimulus package in the offing – and hope that a vaccine will arrive in the not too distant future (although the “superforecasters” see just a 43% chance of a vaccine that can be distributed to at least 25 million people in the US by end of March next year).

As we wrote in our October Monthly (The Case for Banks), we expect US yields will remain supported going in to next year. When our Fair Value model for US 10y yields is stretched to the upside compared to the actual value of the 10y yield as it is today, then it suggests the direction of travel is for higher yields.

Charts Source: Bloomberg, Macrobond and Variant Perception

Bonds also still look overpriced, and are in the process of reverting to the mean, with an overshoot possible.

Charts Source: Bloomberg, Macrobond and Variant Perception

Higher yields can be a risk to equities, but not all yield moves are alike. If yields move higher and the move is not driven by higher inflation breakevens then that is often a sign of a hawkish central bank, which tends to be bad for equities. That is not the case today, where the recent move higher in yields has been driven equally by real yields and breakevens.

Charts Source: Bloomberg, Macrobond and Variant Perception

This is a sign of reflation, and is generally positive for equities.  Higher real yields have often been correlated positively with cyclical outperformance. Financials, industrials and energy have the highest positive correlation with rising real yields.

Charts Source: Bloomberg, Macrobond and Variant Perception

When our China leading indicator is rising it points to the potential for real yields to rise, and for more cyclical outperformance. This should be the case today as long as the virus situation does not become unmanageable and lead to another policy-driven recession.

Charts Source: Bloomberg, Macrobond and Variant Perception

Earlier in the year as the recession took hold, US real yields collapsed. They are now starting to rebound higher on signs of an improving economy and a supportive Fed.

Charts Source: Bloomberg, Macrobond and Variant Perception

As the world economy slowly recovers and as the Fed gives inflation more room to overshoot, this creates an environment conducive to reflation trades (long equities, long commodities and cyclicals over defensives).

The continued but modest rise in yields we foresee over the next few months should continue to be driven by the same reflationary “good” mix of real yields and breakevens.
Thus US equities should not be derailed by the rise in yields, as the rise will continue to reflect a reflationary impulse, driven by the recovery in China.

Charts Source: Bloomberg, Macrobond and Variant Perception