Strategist Warns of Unfavorable Bond Yield Increase Impacting Stocks in 2021

According to Peter Toogood, chief investment officer at Embark Group, government bond yields are likely to rise in 2023 as central banks step up efforts to reduce their balance sheets. This would be "for the wrong reasons," Toogood said, as it would likely be due to inflationary pressures rather than strong economic growth.

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Central banks have been moving away from quantitative easing (QE) over the past year, and towards quantitative tightening (QT). QE involves buying bonds to drive up prices and keep yields low, in order to reduce borrowing costs and support spending in the economy. QT, on the other hand, involves selling assets to have the opposite effect and rein in inflation. Bond yields move inversely to prices.

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Investors have been focused on the possibility of a "pivot" away from aggressive monetary policy tightening and interest rate hikes by the U.S. Federal Reserve and other central banks. This has caused volatility in both the stock and bond markets. Markets have rallied in recent weeks on data indicating that inflation may have peaked in many major economies. This has been a relief for investors who have been worried about the possibility of inflationary pressures eroding profits.

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Toogood told CNBC's "Squawk Box Europe" on Thursday that while the inflation data is great, he is still concerned about bond yields shifting higher for the wrong reasons next year. He said that September was a warning about what can happen if governments continue to spend.

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In September, U.S. Treasury yields spiked, with the 10-year yield at one point crossing 4%. This caused investors to attempt to predict the Fed’s next moves. Meanwhile, U.K. government bond yields jumped so aggressively that the Bank of England was forced to intervene to ensure the country’s financial stability and prevent a widespread collapse of British final salary pension funds. According to Toogood, the transition from quantitative easing to quantitative tightening in 2023 will cause bond yields to rise, since governments will be issuing debt that central banks are no longer buying.

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He said that the ECB had been buying "every single Europe an sovereign bond for the last six years" but that, "suddenly next year ... they're not doing that anymore."

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The European Central Bank has announced that it will begin selling off its 5 trillion euros ($5.3 trillion) of bond holdings from March next year. The Bank of England has said that it will sell £9.75 billion of gilts in the first quarter of 2023. But governments will continue issuing sovereign bonds. "All of this is going to be shifted into a market where the central banks are notionally not buying it anymore," he added. Toogood believes that the change in issuance dynamics will have just as much of an impact on investors as a Fed “pivot” next year.

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"Bond yields are not collapsing when the stock market falls by 2-3%. This is interesting because bond and equity markets usually correlate. I think this was the theme of this year, and we need to be careful of it next year."

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He noted that higher borrowing costs will continue to have an impact on the equity market, with non-profitable growth stocks being punished and value sectors of the market benefiting. Some strategists have suggested that with financial conditions reaching peak tightness, the amount of liquidity in financial markets is likely to improve next year, which could benefit bonds.

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Toogood suggested that most investors and institutions operating in the sovereign bond market have already made their move and re-entered, leaving little upside for prices next year.
He said that after holding 40 meetings with bond managers last month, he found that "everyone joined the party in September, October."