By Hussein Sayed, Chief Market Strategist at FXTM
Equity markets kicked off 2021 on a solid footing. Investors clearly shrugged off the global surge in coronavirus cases and the US Capitol riots. Instead, the focus remains on vaccine optimism and massive stimulus that may come with a Biden administration that is backed by the House and Senate.
Last week President-elect Joe Biden promised a hefty stimulus rollout worth trillions of dollars, which we will learn more about on Thursday when details are announced. That had greater influence on markets than the surprising 140,000 job losses in December that we saw in Friday’s Non-Farm Payrolls report.
Expect markets to continue ignoring the political turmoil in Washington as Democrats, with the support of some Republicans move toward impeachment proceedings against President Donald Trump as soon as today.
What cannot be ignored is the rise in US government bond yields. Last week alone, US 10-year Treasury yields rose 20% making a high of 1.125%. This move in bond yields will likely prompt investors to re-think their strategies for 2021, especially if we see a bigger upside move in the weeks and months ahead.
The equity rally seems to have paused at the start of the week. Futures of all three US major indices are pointing towards a pullback today after all reached new records on Friday. While it is extremely difficult to call for a correction in the current environment in which a synchronised combination of fiscal and monetary policies is taking place, investors need to start thinking about protecting their portfolios.
What we are experiencing in equity markets might not be a bubble similar to the one in late 1999, but there is no doubt that valuations are extremely overstretched. Negative real interest rates have encouraged this massive flood into almost all asset classes, particularly growth stocks, low rated corporate debt and even cryptocurrencies as of late.
The higher bond yields go from here the more difficult it becomes justifying a P/E multiple of 40 on the Nasdaq 100 or a 1.5% dividend yield on the S&P 500. If the Federal Reserve does not take steps to increase purchases of longer-term maturities, we could have 10-year yields well above 1.5% by year end. This means US inflation data is likely to become the most watched indicator over the coming months. According to US 10-year break-even rates, markets now expect inflation to be above 2% on average. While the Fed does not seem in a hurry to raise interest rates, shifting economic dynamics may force them to act sooner rather than later.
Shorting the Dollar was the most recommended trade in currency markets heading into 2021. However, rising yields could now lead to a rethinking of this strategy. If the yield curve becomes steeper and differentials become much wider, expect to see a strong recovery in the Dollar despite the new billions in expected stimulus. According to the latest CFTC data, we are already seeing a trimming of long positions in major currencies against the Greenback.