Longer-dated global sovereign bond yields have broken out significantly to the upside from their recent summer slumber. The US 10- year Treasury yield has spiked by 30 basis points from its recent September low of 1.26% to print a three-month high of 1.56% on 29 September.
In addition, it has also staged a bullish breakout from a six-month corrective decline in place since 30 March high of 1.77% and traded back above its 50-day moving average. These observations suggest a likely continuation of its current major uptrend phase since its pandemic induced capitulation low of 0.33% printed on 9 March 2020 to test its next key resistance at 1.95% in the coming months in Q4.
US 10-Year Treasury Yield
Further potential up move towards 1.95%Source: TradingView (click to enlarge chart)
What’s interesting is that the economic backdrop that is associated with this recent episode of rising sovereign bond yields is different from the prior sharp rallies seen earlier in Q1. During Q1, the prior up move seen in the US 10-year Treasury yield was being coined as a reflation theme play where Covid-19 vaccination roll-out programme started to gain traction and massive expansionary fiscal policies added another form of “liquidity tap” for the markets; US Congress passed a $900 billion stimulus and relief bill in late December 2021. All these measures were considered growth positive that supported the recovery process after a severe economic downturn triggered by the pandemic within a short span of time. Hence, cyclical stocks such as industrials, financials, energy, and materials outperformed in Q1 in line with the rally seen in the US 10-year Treasury yield while technology stocks underperformed.
In contrast, the current economic backdrop has been mired by the “peak growth” narrative where growth in manufacturing and services activities across developed nations including China have either stalled or contracted, lower consumer confidence, higher inflationary pressures including food due to a persistent environment of global supply chain disruptions and most recently the global energy supply crunch that has triggered another round of steep rallies in oil prices.
Thus, the current rally seen in longer dated sovereign bond yields is now being associated with a lower economic growth environment, lack of additional liquidity being flowed into the markets as most developed nations central banks including the Fed have provided clear guidance to start tapering on their respective massive quantitative easing programmes before 2021 ends and a higher inflationary environment that does not seem to be transitory in nature.
Given that monetary policies are now getting less accommodative and the next source of liquidity to quench the thirst for risk assets such as equities will be fiscal stimulus policies. The passage of the additional $3.5 trillion infrastructure spending bill that is being pushed out by the US Administration is now in a limbo state as differences in terms of spending priorities have yet to be resolved among different factions of the Democrats camp.
Therefore, it is likely that we are witnessing a potential stagflation theme play on the horizon this time round rather than reflationary. The next question is who will be the potential winners and losers in terms of US equities under the current rising US 10-year Treasury yield environment?
Let’s look at this table below that highlights the performances of the 11 S&P sectors (data obtained from their respective SPDR Select Exchange Traded Funds), 20-day rolling correlation of the sectors’ movement with the US 10-year Treasury yield and the respective sectors’ 12-month forward P/E ratios.Source: TradingView as at 5 Oct 2021, P/E ratios from FactSet as at 1 Oct 2021 (click to enlarge chart)
Energy Sector has recorded the highest one-month return of 13.20% as well as a significant 20-day positive correlation coefficient reading of 0.90 with the US 10-year Treasury yield which suggests that the SPDR Select Energy Sector ETF tends to see a similar directional movement with the US 10-year Treasury yield. Correlation coefficient is a statistical measure of the strength of the linear relationship between two different variables that ranges from a minimum value of -1 to a maximum value of +1.
Another linkage on its highly positive correlation reading with US 10-year Treasury yield is via higher oil prices that tend to reinforce inflationary pressures which in turn can be one of the factors that trigger a further rise in longer dated global sovereign bond yields seen in the past one month. Also, a bullish oil market may provide an uplift to the profit margins of US energy related companies.
In addition, the Energy Sector’s 12-month forward P/E ratio is relatively cheaper in terms of valuation versus the benchmark S&P 500’s 12-month forward P/E ratio and trades at a discount of -32.84%, the lowest among the 11 sectors. The top five component stocks in the SPDR Select Energy Sector ETF in terms of weightage are Exxon Mobil, Chevron, Schlumberger, ConocoPhillips and EOG Resources.
Information Technology Sector is vulnerable in a rising longer-dated US Treasury yields environment due to higher valuation risk. Its 12-month forward P/E ratio is trading at a premium of +24.88% against the S&P 500’s 12-month forward P/E ratio and it’s the second highest among the 11 sectors.
Also, a further potential up move in the US 10-year Treasury yield implies an increase in longer-term interest rates which may hamper larger scale share buybacks programmes due to higher costs of funding to initiate such programmes. The Information Technology Sector has recorded the highest amount of share buybacks in Q2 among the 11 sectors that was worth $62.8 billion.
In addition, SPDR Select Information Technology Sector ETF’s 20-day correlation coefficient stands at a significant -0.70 with the US 10-year Treasury yield which indicates a further increase in the movement of US 10-year Treasury yield is likely to see a decline in the share price of SPDR Select Information Technology Sector ETF. The top five component stocks in the SPDR Select Information Technology Sector ETF in terms of weightage are Apple, Microsoft, NVIDIA, Visa & Mastercard.
Real Estate Sector has a significant concentration in REITs that tend to face downside pressure in the short to medium-term horizon in a rising interest rate environment. REITs give out a constant stream of periodic dividend pay-outs to investors and they are considered in competition for capital flows with similar “risk free” constant periodic coupon pay-outs from US Treasury bonds or notes.
Thus, an up-trending US 10-year Treasury yield coupled with a lacklustre economic growth environment is likely to increase the opportunity costs for investing in REITS over less risker Treasuries which in turn lead to a potential repricing on the share prices of REITS to the downside.
The above-mentioned inverse relationship between share prices of REITs and Treasuries yields can be backed by data where the recent 20-day correlation coefficient of SPDR Select Real Estate Sector ETF with the US 10-year Treasury yield is at significant level of -0.91, the highest among the 11 sectors. The top five component stocks in the SPDR Select Real Estate ETF in terms of weightage are American Tower Corp REIT, Prologis Inc REIT, Crown Castle Intl Corp REIT, Public Storage REIT and Simon Property Group Inc REIT.
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