The question of when, and how far, we might see US 10-Year Bond Rates increase, is fundamental to how investors — particularly those subject to duration risk (property, long bonds, equities, infrastructure), view the level of rising bond rates on valuations.

We see a reasonable case based on current settings and economic outlook for the US, that 10-year bond rates elevate to 3% and perhaps 4%. There would be a pain point, but it may be higher than markets currently think. How long the Fed takes to act to normalise policy will largely dictate whether bond rates get to 4% in this cycle.

The first step is to answer significant, individual questions in their own right. These are:
— Whether robust economic growth can be sustained?
— Will fiscal stimulus remain supportive or at least readily available?
— Will consumers draw on accumulated savings?
— Will wages growth put pressure on inflationary expectations?
— To what extent is the Fed likely to acquiesce to market reactions in taper and cash rate normalisation?

The second step is to consider the extent by which 10-year bond rates may rise, and the tolerances that the markets and the real economy have to elevated government bond rates.

There is likely to be little argument that the extent of direct fiscal stimulus will decline from the record levels; it having been stimulus required to more immediately support household incomes. Going forward, fiscal support is about political capital (rebuilding America and so on) and economically, longer-duration spending (infrastructure, longer term projects and builds). We see fiscal policy remaining supportive, if only to guard against deflation. When combined with accumulated household savings and healthy wages growth, the US economy is primed for significant growth.

In Figure 1 below, we see the relationship between the Feds Target Fund Rate and Wages Growth. The Fed carefully tracks wages growth and the fund rate adjusts to keep prices and wages in check. If wages growth continues at these levels, then the gap between wages growth and the fund rate will be at a level not seen in 35 years

With wages currently growing at over 3% (and rising) and economic growth likely to move higher through 2022, the pressure on the Fed to incrementally move up the cash rate will be unavoidable.

The timing of this normalisation is important. If focused to employment levels rather than wages growth, then bond markets are likely to react to improving growth conditions and push bond rates higher. If we saw 4% to 4.5% wages growth, the 10-year US Treasury Bond rate would likely breach 3% and if wages growth were sustained at these levels, then test 4%. This would initially be jarring for markets because they seem to have settled on 10-year bond rates of 2.5% to 3% as being the pain point for the economy.

Domestically, with strong economic growth and 4% wages growth supported by long duration stimulus, the US economy is arguably more robust than markets expect and domestic pain perhaps overstated at 3%. It would be painful offshore. We would expect a higher USD and this could be difficult for emerging economies whose monetary policy shadows the US, but unlike the US, are not experiencing significant economic or wages growth. US monetary policy would likely be unwavering to external events, but mindful of financial crisis.

US equities can probably move past and absorb 10-year bond rates at 3%. The US economy is in good shape and hasn’t turn the jets on yet. It is if 10-year bond rates reach 4% that it would be painful for the economy and markets. Can the Fed manage normalisation of rates such that bond markets peak at 3%, rather than 4%? They could, but history is not kind and central banks tend to be too late and then raise too hard. History may well repeat itself through late 2022 and 2023 and the boom turns to bust.

Cameron Harrison have been advising business owners and their families on asset allocation and intergenerational wealth management for over 50 years. We have demonstrated over a long period our ability to manage investments through both the good times and bad by keeping the client at the centre of our business.

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