US government bond yields fell from 1.75% to around 1.20% over the last few months, despite strong growth and consecutive inflation prints of over 5%. That decline in yields could be set to reverse, with Treasury yields appearing out of sync with the current growth outlook. Recent moves have already seen US bond yields rising again but there is still room for them to rise further.

Many equity investors will be watching bond yields closely to assess whether the recent out performance of growth stocks can continue. In a similar fashion to the first few months of this year, rising yields should benefit cyclical and value names. But, if yields slide, growth stocks would likely do well.

So, why have bond yields fallen so much? Well, TGIF. A feeling and acronym commonly associated with the end of a long week, while many bond bears may have been feeling this more than most over the last few months. Moreover, TGIF also neatly helps to explain why bond yields have been falling.

Technicals

In short, there have been lots of buyers and not many sellers of US Treasuries. The US Federal Reserve (Fed) has been purchasing $80bn (£36bn) worth of Treasuries per month for the last year.

Rising demand for Treasuries from the private sector has also added to the pool of bond buyers. Demand for Treasuries has been strong among pension funds that have managed to close or narrow their funding gaps due to strong equity returns over the last year. Private-sector banks have also parked excess cash, built up thanks to healthy consumer bank balances, in Treasury securities.

At the same time, new issuance of government bonds has been limited. The large sum of issuance last year means the Treasury has had plenty of cash available, reducing the need for new issuance of late. All this has led to demand for US Treasuries outpacing supply over the last few months.

Growth

Recent data has shown that the pace of economic growth may be peaking. US business surveys have moderated, while consumer confidence has dipped. Enhanced unemployment benefits and lingering concerns over the Covid-19 Delta variant have led to slower job growth than expected, despite the economy still being down over six million jobs relative to pre-pandemic levels.

Is there too much jargon in the financial services industry?

Inflation

Falling bond yields suggest that investors are buying into the Fed’s view that rising inflation is largely transitory. Maybe that’s no surprise, given 70% of the monthly rise in US core inflation for June was attributed to less than a tenth of the inflation basket. Supply shortages have pushed up prices of used cars, and the economic reopening has led to price rises for airfares and hotels, which should be temporary. Fears of runaway inflation appear to have subsided as medium-term inflation expectations – a driver of bond yields – have come off the boil.

Federal Reserve

The Fed pivoted in a hawkish manner in June. The dot plot now points to two rate hikes in 2023, with the potential for a hike as early as 2022. This suggests the Fed has a lower tolerance for inflation overshooting than the market previously thought. This has led to a faster pace of hikes being priced in over the short term and a lower peak in rates being expected further in the future. The market is suggesting that rates won’t need to rise too much over the medium term because inflation will remain controlled.

However, it is hard to see bond yields remaining this low. Treasury issuance should start to rise as cash available to the Treasury has already been run down. Remember, too, that the Fed is likely to signal a tapering of asset purchases later this year, which should reduce downward pressure on yields.

Fears over a growth slowdown also look overdone. Governments are planning on “building back better”, and business investment intentions are strong, suggesting a return to sluggish growth can be avoided. Vaccines also appear to be effective at weakening the link between cases and severe health outcomes, even for the Delta variant. If the hospitalisation data remains encouraging, the economies of highly vaccinated countries can avoid being derailed by rising cases. Real 10-year treasury yields, which are a barometer of long-run economic growth expectations, have fallen to below minus 1%. That is not reflective of the current US growth outlook, even though the pace of growth set a few months ago isn’t likely to be maintained.

With an uneven global vaccine rollout, the global economy may continue to face supply disruptions that keep inflation high through the rest of this year. Shelter inflation, which tends to be sticky, is also on the rise, while upward pressure on wages could prove to be less temporary. The real game-changer is the coordinated stimulus from central banks and governments, which, if not adjusted appropriately, could lead to inflation lingering. But even if inflation doesn’t run away, real yields should still be higher than they are today.

The outlook for US government bond yields has important ramifications for equity investors. History shows that higher bond yields, against a strong growth backdrop, should benefit more cyclical and value-oriented sectors and regions within equity markets. Volatility may remain, but the central expectation should be for broad economic growth to be sustained and for real bond yields to rise.

This could be the catalyst for value stocks to get back into the game, having been on the sidelines over the last few months as bond yields fell.

Jai Malhi is global market strategist at JP Morgan Asset Management