This week the US 10-year Treasury yield broke through 2.6% for the first time since March 2017, and touched its highest level yet under Donald Trump’s presidency. The key driving force behind the rising yield, which moves inversely to bond prices, is an expectation that tax reform will provide a significant boost to the economy and therefore oblige the Federal Reserve to accelerate its tightening policy. Yesterday the Cleveland Fed’s Loretta Mester argued for three to four hikes in each of this year and the next. But for such a hawkish view to be enacted, most agree that core inflation needs to increase from here. The obvious potential stumbling block to this happening is lacklustre wage inflation. Wages have been edging up but the rate of growth is dreary compared to levels seen during historic periods of comparably tight labour markets. That said, there are signs that wage inflation is set to gain pace, such as last week’s announcement from Walmart that the company is increasing its hourly employee starting salaries to $11 from $9 an hour. So perhaps the strategists who have been calling for the 10-year Treasury to break through 3% since early 2017 will finally see their predictions come true this year.
Despite US Treasury yields normally being highly correlated with the Dollar, the currency has come under further pressure this week thanks to the resurging threat of a potential US Government shutdown. On Thursday, the US House of Representatives passed a makeshift bill to fund federal agencies beyond Friday night but the bill faces uncertain prospects in the Senate where Democrats have more sway. Even if a shutdown is avoided, it is unclear whether Dollar weakness will reverse. Despite depreciating heavily at the end of 2017, some argue that the currency is not in any way exceptionally undervalued relative to historical norms. Whilst US Treasury yields have decoupled and risen without the US Dollar, the current divergence of 10% is half of that seen in 2005 when the greenback was 20% undervalued compared to yields.
Turning to the equity markets, proceeds from the Treasury sell-off have helped indices grind higher. Over the week, $23.8billion poured into equity funds and investors are currently the most overweight equities relative to government bonds since August 2014. The US S&P 500 and UK FTSE 100 both made all-time highs this week, prompting a few commentators to express concern that the “goldilocks scenario” may be running out of steam. But with economic data remaining supportive, notably the JPM Global Purchasing Managers Index at seven year highs, market sentiment remains buoyant for now.