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Weekly newsletter |19 February 2021| Bonds Buckle

Aarinder Lidder - Feb 19, 2021

Welcome to our weekly newsletter where I discuss investment markets and what to look out for in the days and weeks ahead. I tend to discuss equity markets and if you recall last week equity markets were still in this uptrend. We are at all-time highs for a lot of equity markets globally. We had seen a little bit of a pull back at the end of January, but the market picked itself up and off it pushed even higher.

I want to focus this weekly newsletter on the bond markets. Every now and then something happens in markets, where you get an accelerated move. This beautifully illustrates all the ways that different assets and markets are correlated, react to each other and move.

We have got one in progress and this relates to the bond market. In the last week and the last few days, we've seen yields on government debt particularly in the US, spike higher. If you look at the 10-year US Treasury yield, we have seen the yield push above 1.3%. This is the highest level we've seen since the pandemic started. The speed of the rise that we've seen is the fastest increase in yields that we've seen in three months. That takes us back to the beginning of the vaccine trade when we saw a selloff in bonds.

When yields rise that means the value of those bonds, in this case, long term US Treasuries fall, and if you held a bond fund for example, you will have seen that it's fallen about 5% in value in the last few days. This is a big move and it’s a reminder that bonds are quite volatile. They are not the safest asset that you would often think. Bonds are quite volatile, but what we've seen is the wobble in bond markets and the bond market sell off.

Events like this don't happen in isolation, we've seen this bleed over into equity markets. This is a sign of nervousness in the last few days and we've seen equity markets start to pull back a little bit, just sort of 0.5% a day and nothing like a 2 to 3% move in a single day which often grabs headlines.

We started to see nervousness around equity markets. Investing is like a skyscraper and I've used this analogy before because it works quite well. Think of the lower risk assets as the foundation, such as bonds. As you move up the different storeys of the building you get the higher risk assets. At the higher end you've got equities and at the very top you've got things like emerging market equities. As the building is structured, the vibrations and movements at the top exist. The top of the building will move ever so slightly because of that levering affect. At the bottom of the building the foundations are what keep the building up right.

In a portfolio, imagine there's an earthquake and it causes the foundations to wobble. The building wobbles and becomes exaggerated the further you go up.  The vibrations carry on and eventually you can get the whole thing to come down. To use that analogy, when we started to get some seismic moves in bond markets; the thing that underpins a lot of risk assets. You can start to see cracks showing in equity markets. This can present itself to be a good time to buy good quality companies at a discount.

We have also got people starting to look for a haven asset. We're starting to see people move into the dollar and buying the dollar. If we think about what's been happening in equity markets in the last years certainly since the summer, I talked a lot about the dollar. If you get the dollar right, you seem to be able to get a lot going right in your portfolio. A weakening dollar has caused a lot of assets to spike higher, push up commodities, emerging market assets - particularly equities.

US equities have started to pick up because the dollar is weakening. We've seen a movement of people into the dollar and as a result it has strengthened. That means that all those trends and trades are starting to unravel. As a result, we are starting to see a bit of weakness in equity markets and equally you start to see the currency exchange rates change. The US dollar strengthened against pretty much every county out there, including the Canadian dollar.

 We're getting some interesting moves in markets and we are seeing how all these different assets are correlated because the moves are quite aggressive now in yields. We are seeing the yields spike on some of these treasury’s and developed market bonds that are issued by governments.

When yields spike, the values fall. We start to see this spin out into other assets. We want to see if it does become more sustained and what eventual impact on equities it will have. The rise in yields is the idea of continued government stimulus, or in the case of the US, some big stimulus that Biden is still promising. He's been on record saying now is the time to go big and markets are seeing that as a sign that this is going to push and boost US economic growth.

If it does, as a general pattern, bonds don't do very well when we've got a very booming economy and so that is negative for bonds. The way they're going to fund that government stimulus is to issue more US Treasury. Increased supply means that supply demand relationship starts to cause the supply to increase, demand not so much. Therefore, the value of the treasuries starts to fall so that the prices go down resulting in yields going up. We're seeing a slight repricing and people thinking that inflation is going to come back.

Bonds are a bit like equities; there are different types and different areas of the market. if you've got some strategic bond funds, for example, you would have noticed that they have probably been doing quite well in the last week - they certainly haven't been plummeting in value.

This is because there will be other areas of the bond market that will still appear attractive such as corporate bonds. Therefore, it isn't the case of just fleeing bonds entirely. As bond yields start to increase, if you are investing in equities for the yield they produce, as equities become more expensive, that yield becomes less attractive, comparatively to what we are now starting to see on bonds. For an investor who is after yield they will start to look at the two and think that equities are priced higher now with bonds not so much. Therefore, I could get an attractive yield. We have therefore started to see some movement across. That is also what’s starting to cause this weakness in equity markets.

It's not often that you see bonds and equities weaken at the same time. It does happen but that's when you get these seismic movements which present itself as good buying opportunities. It's fascinating to watch. We could get to next week and the narrative changes again. We are still in an uptrend for equity markets now.

It's been an interesting week as we’re starting to see the bond market yields rise. Another relationship that's being tested is gold. Gold is starting to fall again. It's going down, heading towards $1750 per oz level. If it breaks through there, it could mean the price of gold starts to unravel further.

As yields increase in the economy, the attractiveness of gold starts to diminish. Gold is inert, it doesn't do anything. It doesn't produce an income or anything like that. If the dollar strengthens then that is also bad news for commodities.

That would mean it would be doubly bad news for gold. We are starting to see all these relationships. Those headlines you see, you can start to see how they are all joined up. It's fascinating to watch. It's very early days in this trend and it's likely to change in the coming days as narratives flip on their head. Bonds give you a signal to what's going on and an understanding as to what's going on in other parts of the market. It is good to keep an eye on the yields of US treasury’s and interestingly where we are now with equity markets. It feels very much like equity markets last year just before the pandemic struck.

To leave you with a thought, this time last year we were largely dismissing, or markets were largely dismissing the coronavirus, and the potential impact it could have. Fast forward a year and we have a vaccine, but we are largely dismissing the impact these new variants could have.