Equities were mixed during February. Markets bounced early in the month as concerns over new virus variants and their potential to reduce vaccine efficacy eased. Improving vaccine sentiment and generally better than expected economic data led to a sell-off in government bonds. The increase in yields accelerated into month-end as Fed Chairman Powell testified that he remained unconcerned about the inflation outlook and US jobs data came in ahead of expectations. The volatility in the bond market led to a pullback in equities.
The increase in bond yields was particularly pronounced in the US where investors have become concerned that President Biden’s stimulus package will result in an increase in inflation. This has led to a spirited debate between economists about the potential for inflationary pressures to become entrenched and potentially choke off the economic recovery. The debate has not just been confined to the US. Bank of England chief economist, Andy Haldane, warned that central banks ran the risk of becoming complacent on inflation as the economy recovers from the coronavirus pandemic.
Outside of a resurgence in the virus, the potential for significantly higher bond yields is the biggest risk facing equity markets. Every strategist/economist/fund manager has offered their view on what rising yields mean for equities. The honest answer is that no-one really knows. Economists still can’t even agree what the primary determinant of long-term interest rates are. The best guess, somewhat counterintuitively, is short-term rates. Markets are complex adaptive systems where relatively small changes in inputs can result in significant changes to outcomes. We believe that a rise in yields is more likely to result in changing relative valuations within markets, rather than the catalyst for a sustained market reversal. Volatility, however, will remain higher than usual.