Are Yields Too Low for the Post COVID-19 World?

• The Russian vaccine announced on 11 August is unlikely to be the leading cure-all for COVID-19 as it appears to be one among many legitimate and speculative news releases for treatments that promise an end to the pandemic. Nevertheless, the market reaction to the announcement provides an important signal for investors as it caused 10-year US Treasury notes to plunge 0.75% in price and 30-year bonds to drop 2% in value. That day, the US yield curve steepened 6 basis points. The world’s most expensive negative yielding debt fell in value. And gold fell nearly 5%, its biggest daily drop in 7 years.  

What is this telling us?

• Following a confirmed COVID-19 treatment, global yields may rise. A doubling in 10-year US Treasury yields to 1.25% in a year’s time seems likely. If Federal Reserve (Fed) rates remain at zero, the yield curve could steepen, though not far above its long-term average.

• Equities may rally modestly on a post COVID-19 recovery, but the performance dispersion may allow opportunities for alpha as winning and losing sectors rotate. A rotation within the equity markets benefiting beaten down cyclicals, such as Financials, could accelerate.

• Until better health care treatments for COVID-19 are found, certain parts of the economy – such as hospitality and travel – could remain highly depressed.

• Financial markets are likely to continue to have periodic bouts of fear and relief. Bond yields, gold, value and growth stocks may exhibit negative correlations between assets tied to a cyclical recovery and those that are considered defensive.

Implications for Asset Allocation

• For longer-term portfolios, rotation between expensive COVID-19 defensives and cheap COVID-19 cyclicals is preferred. While Citi analysts continue to favor Unstoppable Trends (Asia, Healthcare and Digitization), they prefer a balance of the best values in both. Citi analysts added allocations to global small and mid-cap shares (ex-US), and European large cap shares that offer value and yield, and have not already fully recovered.

• Citi analysts reduced short- and intermediate duration US Treasuries to neutral from overweight as yield has fallen to about 0.2%. Their low price sensitivity to changes in interest rates (duration), provides little diversification in the event of an equity correction. Citi analysts also shifted medium-duration US Investment Grade corporates overweight to neutral as yields have fallen to about 1.25%, and reallocated the overweight to US high yield. At a roughly 5% yield, the greater volatility is compensated for with both wider spreads and less sensitivity to interest rate movements.