Bond Yields (Part II)
January 6, 2021
Upward pressure on bond yields has been in our forecast since mid-September and a key piece in our preference to add cyclical/value exposure (Financials, Materials and Industrials). In past editions, we explained that the slope of the yield curve (defined as the spread between 5-year and 30-year Treasury yields) as a more important factor for the relative performance of cyclical/value sectors. Specifically, spreads wider than 130bps have resulted in cyclical/value sector outperformance. The ‘sweet spot’ for all three sectors to outperform is in the ~130bps-140bps range. Once beyond 140bps, we’d expect outsized gains for Financials (banks) only. The 5/30-year spread was as wide as 139.5bps this morning and now at 138.7bps.
At some point, upward pressure on yields has potential to exacerbate valuation concerns. Tech is the most richly valued sector and it’s no surprise the group is lower this morning. The preference for cyclical/value sectors could begin to look more like a ‘rotation’ out of Tech when 10-year Treasury yields trade above 1.08% (now 1.044%). Software companies with operating margins of -5% and lower would experience the most violent rerating.