We stick with our expectation (in line with the CS house view) that the US 10-year government bond yield will rise to 2% by the end of 2021 (see Rising yields: how far, how much of a problem, and which regions and sectors benefit, 26 Feb). Our forecast is driven by: i) our expectation for 8%+ US GDP growth this year; ii) the biggest gap on record between ISM and the 10-year bond yield; iii) more of a short-term inflation hit (NFIB and ISM prices paid both imply significant increases in inflation); and iv) the Fed buying just a third of net issuance. Hence, we believe that bond markets’ recent ability to ignore bad news will be short-lived.

However, in contrast with many clients we have spoken with, we believe the rise in yields will be driven almost entirely by inflation expectations (as has been the case so far), not by the real bond yield (i.e. TIPS yield), which is close to levels seen in mid-November 2020.

We do not expect a meaningful rise in the TIPS yield, given: i) the stage of the cycle: Post the GFC, the TIPS yield troughed when GDP was 3% above its previous peak (and 10-year inflation expectations had already hit 2.7%); ii) a very dovish Fed: We believe TIPS yields are driven by the Fed, while inflation expectations are driven by economic activity/structural factors. We believe the Fed remains very dovish, reflecting the desire to seek ‘maximum employment’ with the real unemployment rate currently at 9.4% (triple pre-pandemic levels). We think that the Fed will tolerate core CPI rising to c3% and will also be very careful to avoid a repeat of the ‘taper tantrum’; iii) backdoor yield curve control (YCC) by the ECB and BoJ: The risk of ECB and BoJ YCC is capping US bond yields at a time when the currency-adjusted yield differential between US and European/Japanese bonds is close to a five-year high; iv) debt arithmetic: Real bond yields need to be kept around current levels to stabilise government debt and allow unemployment to fall; v) inflation uncertainty drives demand for TIPS: The greater the degree of inflation uncertainty, the more investors will pay to hedge it by buying TIPS (and inflation uncertainty is very high); vi) the Bank of Canada announced tapering last week and the real bond yield has increased by only 1bp. We find little fit between TIPS & GDP and TIPS & productivity.

Impact: A rise in inflation expectations leads to a weaker dollar, is positive for equities (until inflation hits 3%), positive for both GEM and Continental Europe and should see cyclicals outperform, with banks and materials being the two best-performing sectors (we are overweight banks but recently reduced our weighting of non-financial cyclicals; see Some warnings on cyclicals - add to 'cyclical' defensives, 22 Apr). Value should also outperform.

If real bond yields rise: Positive for the dollar, negative for gold, negative for equities (each 50bp on TIPS takes 6% off fair value), negative for GEM and US and positive for Japan and Continental Europe. Rising TIPS yields are negative for long-duration assets and positive for banks (but slightly negative for non-financial cyclicals), and hence value tends to outperform.

Conclusion: If we are correct about inflation expectations rising but TIPS yields not moving much, then it makes sense to overweight equities structurally until inflation hits 3%, overweight value in Europe, and overweight cyclicality in total (we do this via financials increasingly) but this does allow investors to focus on value growth (semis, industrial gases, spirits, testing comps). NN Group, LafargeHolcim, CRH, Dana and Citigroup (all rated Outperform) are among the stocks that stand to benefit from rising inflation expectations.