CGS-CIMB analyst Lim Say Boon has advised investors in the Asia Pacific region to “overweight” equities and “underweight” bonds in their portfolio.

This is as he forecasts the steepening of the US Treasury yield curve that’s driven by aggressive monetary and fiscal stimulus.

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“An almost 6-year cycle of yield curve flattening appears to have ended late last year. A cycle of steepening may now lie ahead”, Lim predicts.

Lim also sees the coming “fiscal explosion” in the US as a near term driver, and says that many explanations have been offered for the steepening of the US Treasury yield curve. 

It could be the size of the US pandemic stimulus, the Federal Reserve’s new 2% average inflation targeting policy, and the growing possibility of a Joe Biden victory in the US Presidential Election.

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However, Lim highlights that the common factor linking the above three explanations is monetary and fiscal policy stimulus, which over the long-term tends to fuel higher inflation.

He adds that there may be even bigger forces at work, such as long-term, multi-year, forces of mean reversion, which may be fuelled further by even more government spending after the Nov election.

The long-term mean reversion in the yield curve can be traced back to the consequences of the relentless fiscal and monetary stimulus of the US economy since the Global Financial Crisis/Great Recession of 2008-2009.

The Fed tripled down on quantitative easing through so-called QE1, QE2 and QE3, and now to an open-ended, unlimited bond-buying programme to cope with the economic impact of Covid-19. And this has now been accompanied by the biggest US budget deficit (16% of GDP in 2020) since World War Two.

According to the US public policy organisation “Committee for a Responsible Federal Budget”, Joe Biden’s proposals total US$10.35 trillion ($14.05 trillion). The committee’s central estimate is that a President Biden would add another US$5.6 trillion (after interest costs) to the US deficit from 2021 to 2030. 

Even if incumbent US president Donald Trump wins a second term in the Nov 3 election, the difference in the deficit numbers are not likely to matter much to inflation expectations. The committee estimates Trump’s spending and tax cut proposals total US$4.85 trillion. 

Net of savings, the Trump agenda offers a net fiscal boost of US$4.7 trillion, and (after accounting for interest costs) adds another US$4.95 trillion to the US deficit over 10 years.

All of which suggests a lot more US Treasuries will have to be issued for years to come, putting upward pressure on US Treasury yields.

In addition the massive monetary and fiscal stimulus undertaken all over the Developed Markets (DM) – and in particular, the massive amount of asset purchases undertaken by central banks – has increased correlations between stocks and bonds.

Correlations have also gone up across the board, with 1-year correlations considerably higher than the 6-year correlations, note Lim. DM corporate credits are now highly correlated to DM equities. For example, the 1-year correlation between US Investment Grade corporate credits and US stocks is now 0.7.

US high yield credits now have a 0.9 correlation with US stocks, and there are also the same high correlations between European corporate credits and US and European stocks. 

As such, Lim feels “there is little diversification value there”. He adds that “with yields and rates scraping the bottom of the barrel, the argument for investing in bonds for income and safety (at least in mark-to-market terms) is also questionable.”