After the stock market’s worst week in two years, its Valentine’s Day date with US inflation numbers looms large.
The last official reading for headline consumer price inflation in the US was 2.1 per cent, while the consensus expectation among economists is for a fall in the January number to 1.9 per cent, according to Bloomberg. If inflation were to come out significantly above this on Wednesday, the equity markets would face renewed pressure.
Equities started to sell off sharply after a surprisingly high number for wage inflation in the January unemployment report pushed Treasury bond yields upwards.
“With US companies granting one-off bonuses or wage increases on the back of the tax deal, it looks as though the tightness of the labour market is now showing up in some wage inflation,” noted Chris Iggo, CIO fixed income, Axa Investment Managers. “This is good for growth but it also reinforces the determination that the Federal Reserve has to normalise the level of interest rates.”
Yields on 10-year Treasury bonds are still very low by historical standards at about 2.85 per cent, but they have risen enough to force a rethink about equity valuations. Low yields on bonds during the post-crisis era, stemming from intervention by central banks to keep interest rates low, have been a key part of the “bull case” for equities, and prompted investors to invest in stocks in search of a yield from their dividends.
Treasury yields have already risen enough to throw into question this justification for holding equities. For significant periods over the past five years, equities have yielded more than bonds. That ended with a sharp increase in bond yields on election day in 2016, as markets interpreted the arrival of US president Donald Trump as heralding a return to more growth-friendly and inflationary policies.
An apparent decline in inflation almost brought the yields on the two asset classes back into alignment last summer, but the excitement over the US tax cut has since driven them much further.
Entering last week’s sell-off in equities, bonds yielded a full percentage point more than equities for the first time since they peaked at the end of the so-called Taper Tantrum in 2013, when then Fed chair Ben Bernanke told investors the central bank would scale back its bond-buying programme.
Before the financial crisis in 2008, bond yields had far exceeded dividend yields for more than 50 years, in line with the logic that investors needed to be compensated for the risk that inflation would erode returns from bonds. Most of the recent increase in bond yields has reflected rising inflation expectations. Recorded inflation remains muted.
This post originally appeared on Financial Times