Who are the winners if the 10-year yield continues to rise?

Treasuries a good reflection of perceived economic health

The treasuries market provides a key barometer of economic health, with investors typically seeing fixed income as the ultimate safety haven in times of trouble.

The past year has shown how yields collapse at time of economic hardship, as allocations towards havens help drive prices lower, and yields higher.

The St Louis Fed highlight the trajectory of 10-year yields during times of economic distress below, with shaded areas denoting recessions. The chart also highlights one of the key drivers of yields, with the level of inflation providing a key driver of pricing.

Certainly, when inflation is high, it provides less incentive to obtain fixed income products that pay little in return. To do so would often result in a negate real return. That is worth bearing in mind when we consider the fact that many believe we are on the cusp of a major reflation trend.

With companies seeking to regain lost earnings, and supply often restrained, prices are likely to risk over the remainder of the year. That points towards a potential continuation of the resurgence seen in the US 10-year yield seen over recent months.

Economic recovery likely to fuel further upside for yields

Rather predictably, yields rise when the economic outlook improves, with investors feeling increasingly confident to allocate funds away from this haven asset. That is reflected in part with the correlation below, where the US composite purchasing managers index (PMI) typically tracks alongside the US 10-year yield.

Notably, this has seen a major divergence over the course of the Covid-19 pandemic where stimulus-fuelled outperformance in manufacturing has failed to initially provide much of a bounce in yields.

While we could see some downside in the PMI readings, it seems more likely that we will see yields continue to move higher in a catch-up move. With US President Joe Biden seeking a $2.25 trillion stimulus package to add to the recent $1.9 trillion coronavirus support bill, there is plenty of growth yet to come in the region.

Rising yields bring tech underperformance

2020 saw huge tech outperformance over the course of the pandemic, with global lockdowns seeing traders funnel their money towards digitally-focused stocks.

However, the wider picture highlights the growth/tech stocks do typically outperform at times of economic weakness, whereas those companies that are more pro-cyclical in nature oerform better when the economy is strong.

That is evident below, where the Russell 2000/Nasdaq ratio (value/growth) is plotted against the 10-year yield. Clearly, the recovery in yields brings a shift towards companies that are more reliant upon a strong economy, with tech underperforming as a result.

The long-term downtrend between value and growth does highlight that we are likely to ultimately see those Nasdaq names ultimately come back to strength. However, the prospect of higher economic growth and inflation does signal the possibility of further tech underperformance in 2021.

FX correlations highlight JPY role

From an FX perspective, we are talking about risk attitudes on the whole. A number of different currency pairs will be highly correlated with the US 10-year yield, as traders reflect their risk sentiment in a number of forms.

The chart below highlights exactly that, with a host of risk vs risk-off pairs correlating well with the US 10-year yield (black line). Particular focus is shown towards the yen, which has provided a good reliable haven role.

However, EUR/USD also provides a similar trajectory which highlights the haven role played by the dollar. Interestingly, those two havens can be plotted against eachother to find that within USD/JPY, the dollar takes the risk-on role, which perhaps highlights why JPY is the more reliable currency to utilize for the haven side of the trade as it tends to fluctuate less in terms of its perception.

Commodities shows how golds haven role is often relative

The commodities markets provide a final area of focus where risk attitudes are clearly reflected. The past year has seen a sharp rise in gold prices, with traders questioning whether the precious metal is a good haven or not.

However, the chart below highlights how golds haven role is often best taken in relative context. The ratio between copper and gold plotted against the 10-year yield shows how traders will typically buy copper and sell gold when yields are on the rise.

So-called ‘Dr. Copper’ has long been heralded as a key barometer of economic health. However, with that copper/gold ratio having stretched so far upward, one has to question whether the catch-up will be a decline in that ratio or a sharp rise in yields.