With help from Friday’s “mere” quarter million job gains, long-term US yields have risen only half as much as they did in the immediate aftermath of the Global Financial Crisis. Citi analysts believe the largest reason yields have not risen faster is the near-record level of COVID-19 infections globally, in spite of vaccine success in developed markets. In Citi’s view, it is only a matter of time and vaccinations before the global recovery accelerates and Citi analysts expect bond yields to reflect a substantial change in economic activity.
Citi analysts find ourselves in general disagreement with both sides of the present “consensus” views regarding rates. Specifically, Citi analysts believe that bond markets are underestimating the coming strength of the economic recovery and overestimating the intermediate rate of inflation. The net effect, in Citi’s view, is a potential yield of 2.0% for the 10-year US Treasury by year end, and 2.5% during the coming couple years of expansion.
A 2.5% nominal US Treasury yield would only equal the inflation rate of the coming 10 years based on trading data from inflation-linked US bonds. This is unusual as the US has not previously sustained long periods with real yields below zero. Citi analysts also believe that a 2.5% 10-year is unlikely to hamper the expansion, but may continue to challenge valuations of growth equities and speculative investments.
With a strong global recovery and a rising rate environment in mind, Citi analysts reiterate some prior conclusions.
Given our views on rates, Citi analysts are staying underweight in bonds. Citi analysts are adding to less interest rate sensitive securities such as floating rate bank loans.
Citi analysts expect market volatility as the economic recovery accelerates. Just as employment data surprised to the downside last week – and markets rallied – it is as likely that employment and economic data may surprise to the upside – and markets may fall. That said, the trajectory of equities could tilt higher. Citi analysts upgraded equity portfolio quality already by reducing cyclicals with poor balance sheets in the SMID sector.
Mean reversion is likely to persist. Thus, Citi analysts continue to favor COVID-19 cyclicals, non-US equities and dividend growth shares even in the face of volatility and rising rates. Citi analysts would add to US growth equities once their valuations reflect further normalization in US long-term yields.